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Courtesy of Pharmboy of Phil’s Stock World
In Figure 1 below, typical up trends and down trends are shown. These zigzag patterns are seen all the time, but why do they form? Let’s say someone bought a stock at a certain point. If that stock went up, but pulled back to the original purchase price, they will often think that it’s an opportunity to buy more at their original price, thus adding to their position. This is also the same for shorts when they are able to short a stock at the same price they shorted previously. Then why do peaks form? People sell (or cover) to take profits. Obviously, any increase in selling will pull the stock back. Those who bought at a lower level may start buying again. This repeats and repeats until 1) there is no more stock left for people to buy, or 2) there is too much supply and not enough buyers. On a larger scale, this is how bull and bear markets begin and end.
Figure 1 Typical up and down trends.
The following basic chart patterns will be covered in this chapter:
• Trends & Trend lines
• Support & Resistance
• Neutral Ranges
• Triangles (Symmetrical, Ascending, Descending)
• Flags, Pennants and Wedges
• Double Tops & Bottoms
• Head & Shoulders
• Cup with Handle
• Entry & Exit Points
• Low Risk Trading
• Selling Short
Trends & Trend lines
An uptrend is drawn from the extreme low of the bar that starts the uptrend (Figure 2), up and to the highest minor low point preceding the highest price on the same trend. The key here is that the line drawn must not pass through prices in between the two low points (Figure 2 and Figure 3). The line extends upward past the highest high point.
Figure 2. Trend line drawn correctly.
Downtrends lines are drawn exactly opposite of the uptrend lines, where the line is drawn for the highest high to the high prior to the low price of the trend. The line does not pass through price points prior to the lowest low of the trend, but can pass through price point past the lowest low (Figure 4).
Figure 4. Downtrend line of Caterpillar.
How does a trader identify a chance to a trend? When drawing the trend line, the 1) trend line is broken, 2) The trend no longer makes a higher high in an uptrend or lower low in a downtrend. For example, in an uptrend the market sells off but when prices rise again they do not make a higher high, or 3)Prices go below the previous sell-off in an uptrend or go above a previous rally in a downtrend below gives an example.
After the previous selloff low (Figure 6; #3) was broken, prices quickly retreated from the $102 price range to the $70 price range.
Support & Resistance
Support is a level where price demand is so strong. The stock will stop its decline, at least temporarily, because there are enough buyers to support the price. Resistance is just the opposite. There are enough sellers at that point that the stock will continue to sell to keep its price from going higher. Figure 7 is an example of the Diamonds (DIA) support and resistance lines:
At the start of the chart, there is a clear line of support at $82.5 where the stock bounces off of that line. Then there is a gap up, and then the support moves up. That becomes the support-resistance line. Certain gaps are so powerful that traders who buy at support (or short at resistance) and will join the prevailing direction of a stock’s move so that it does not go against them from originally shorting the stock. In Figure 7, the same support line turns into resistance. Notice how the stock cannot break through the $105 level after the resistance line has been breached – That is due to the sellers keeping the stock price down. Many support levels turn into resistance and vice versa.
What happens when a stock is equally bound by support and resistance? That is called a neutral range or a trading range as shown in Figure 8.
Figure 8. Neutral trading ranges.
A trading range signals that supply and demand are in balance. A range is a consolidation pattern, meaning that a stock is waiting to either continue its current trend or reverse it. The winner is determined through a breakout to the upside or a breakdown. In MRK, the can see that the stock broke down below $30 on several occasions, which was the lower range support level.
Triangles: Symmetrical, Ascending, Descending
In addition to trading ranges, there are symmetrical, ascending, and descending triangles. All triangles are consolidation patterns.
Symmetrical triangles are formed when price points form lower highs and higher lows. The easiest way to determine if a stock is in a triangle is to draw mini trend lines and to see if it looks like a symmetrical triangle. The important thing to note here is that daily prices may fluctuate without much movement until a breakout or breakdown occurs. For Choice Hotels (CHH), there is a clear breakout to the upside. Symmetrical triangles, in many cases, have an equal chance for a continuation or a reversal (this one reversed back to the low) (Figure 9).
Descending triangles are just the opposite. There is a support line, but the highs are getting lower and lower. This pattern indicates that the sellers are in control. These are bearish continuation formations that typically breakdown. Petrohawk (HK) has broken down considerably below the descending triangle (Figure 11).
Figure 11. Descending Triangle.
Flags, Pennants and Wedges
Flags are a technical charting pattern that looks like a flag with a mast on either side. Flags result from price fluctuations, within a narrow range, and mark a consolidation before the previous move resumes. Pennant formations are usually treated like flag formations because they are very similar in appearance, tend to show up at the same place in an existing trend, and have the same volume and measuring criteria. Flags and pennants are among the most reliable of continuation patterns and only rarely produce a trend reversal. The only difference between the two patterns is that a flag resembles a parallelogram (or rectangle) marked by two parallel trend lines that tend to slope against the prevailing trend. The pennant, however, is identified by two converging trend lines and more horizontal which resembles a small symmetrical triangle. The important thing to remember is that they are both characterized by diminishing trade volume and though different, the measuring implications are the same for both patterns as demonstrated in the above illustration. A wedge is a technical chart pattern composed of two converging lines connecting a series of peaks and troughs. All formations are shown in Figure 12.
Figure 12. Flags, pennants and wedges.
Double Tops & Bottoms
Now, let’s look at double tops and double bottoms. A double top is a reversal pattern that forms after an uptrend. The tops are usually similar and there is strong resistance present above GTE’s double top in Figure 13.
Figure 13. Double top in GTE.
Figure 14. Double bottom in MEMC.
Head & Shoulders
One of the most popular reversal patterns is the head and shoulders pattern – the one that started the crash of 2008.
A head and shoulders pattern, such as the one for the S&P 500 in Figure 15, is formed with three successive peaks. The left and right shoulders are lower than the head, which is the highest peak. The two shoulders are similar. The pattern is complete when the support level (neckline) for the peaks is broken. The head and shoulders is one of the most reliable long-term reversal signals that exists today.
Figure 15. Head and shoulders pattern.
Cup with a Handle
Below is a chart of Arch Coal (ACI) and shows a perfect example of a cup with handle. A cup with handle pattern was developed by William O’Neil in 1988. He is the founder of Investor’s Business Daily. The pattern consists of a cup, which is shaped like a bowl or a rounded bottom, and a handle, which is a small continuation pattern or a flag. The cup with handle pattern together is a highly reliable continuation pattern that signals a breakout may occur imminently to the upside. On ACI’s chart, we can see a continued move to the upside following the pattern (Figure 16).
Figure 16. Cup with handle pattern.
Entry & Exit Points
Figure 17. Chart showing the entry and exit points for STEC.
For example, Figure 18 shows consolidations and breakouts of the DIAs, and identifies the difference between standard flags, triangles, wedges, pennants, and other formations and their respective reliability levels. By using these chart formations, a trader knows when to place a trade. In general, a winner is apparent within 1-3 days of a major breakout.
Figure 18. Chart of the DIAs and its breakouts and consolidation pattern.
Candlestick charting can assist a trader in identifying warning signs in advance and give enough time to react. The basics are: continuation, and reversal patterns complete with pattern recognition, and some reliability levels. Figure 20 shows a Merck (MRK) candlestick chart.
Figure 20. Candlestick chart of MRK showing different signs.
As with all patterns, remember that a pattern’s likely move is based on what has occurred most frequently. There are pattern failures in which case the trader should cut their losses quickly.