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Basic Technical Patterns: The Foundation of Common Pattern Identification

Pharmboy’s latest chapter in his TA eBook – Chapter 7! - Ilene 

Links for previous chapters:

1. Understanding Market Cycles: The Art of Market Timing (Chp. 1),

2. Dow’s Theory of Markets (Chp. 2),

3 & 4. Fundamental vs. Technical Analysis and Types of Technical Trading (Chps. 3 & 4).

5. Stock Charting Basics: How to Read & Understand Stock Charts (Chp. 5 here.) 

6. Using Moving Averages for Long and Short Trades (Chp. 6)

Basic Technical Patterns: The Foundation of Common Pattern Identification

Courtesy of Pharmboy of Phil’s Stock World 

History tends to repeat itself, and trend lines, triangles, and other patterns do work in TA.  Charts show the collective opinions of all market participants for that day, month, or whatever timeframe that is used.  Charts are direct evidence of the trader’s beliefs and feelings, and each movement reflects a bit of human emotion (or at least it did before speed trading – HAL9000).  So, it should be no surprise that patterns repeat themselves over and over.

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
•    Candlesticks
•    Summary

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.


Figure 3.  Trend line drawn incorrectly.

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.

[http://education.wallstreetsurvivor.com/images_article]

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.

Figure 5.  Trend lines and identifying breakdowns.

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The trend line on Dryships Inc. was broken 2 (Figure 5).  When prices rebounded they could not make a new high. 3. The price drops below the previous sell-off low.  Was the uptrend really broken after these three things happened? Let look at the next part, as the trend change confirmed.
 
Figure 6.  Trend lines and breakdowns continued.
 

http://education.wallstreetsurvivor.com/images_articles

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:

Figure 7.  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. 

Neutral Ranges

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).

Figure 9.  Symmetrical triangle.
Ascending triangles are different because there is a horizontal resistance line where the highs are constant but the stock is also forming higher lows. Typically this means that the buyers are gaining control (accumulation) as each price point makes a higher low.  Ascending triangles are usually continuation patterns and breakout to the upside (Figure 10).

Figure 10.  Ascending triangle.

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.

[investopedia.com]

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.

A double bottom is a reversal pattern that forms after a down trend. It is the complete opposite of a double top and instead of strong resistance, there is strong support. In Figure 14, MEMC (WFR) has formed a double (triple) bottom.  Just like the double top, a double bottom is easy to identify.

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

Technical analysis warns traders and investors when a trend changes against their favor.  A trader can use chart patterns and price-volume divergence to join the ranks of the “smart money” that can accumulate long before other traders catch on.  Traders accumulated STEC at the bottom of Figure 17, and several entry points were clearly defined for other chartists to get on board (as noted by the green arrows).  A trader can identify reversals (red arrows), and know when to exit a position.

Figure 17.  Chart showing the entry and exit points for STEC. 

Low-Risk Trading

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.

Selling Short

Technical analysis is used not only for buying stocks, but nine out of 10 investors/traders do not know how to sell stocks short, or are afraid to do so.  Figure 19 shows the Chevron (CVX) chart and examples of where to sell short using moving averages and bearish engulfing signals:
 
Figure 19.  CVX short selling.
 
Candlestick Charts

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.

Summary: Combine Indicators to Support Trading Decisions
 
There are dozens of indicators that are available to make trading decisions, including MACD, RSI, Stochastics, Money Flow, and many others.  This handbook touchs on the main indicators.  Figure 21 highlights indicators that can be used to confirm trade decisions for Verizon (VZ):
 
Figure 21.  Indicators for trade decisions.

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. 


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