It would be a mistake to suppose that any changes
in trend dynamics can occur in a moment. The transition period is necessary for
major changes on market. Transition periods and their meanings analysis for
market forecast bring us closer to the theme of price patterns.
First of all,
let us define what it is. Price patterns are figure or unit which appear at the
stock price or commodity assets’ charts. These figures, or units, are divided
into some groups and can be used for market dynamics’ forecast.
All price patterns are divided into two big groups
– reversal pattern and continuation pattern. Judging by the name of patterns, the first one indicates that important fracture is in the trend dynamics. And the pattern of continuing trend testifies that the market paused.
Probably trend was
developing too fast and temporally came into overbought or oversold condition.
Then after intermediate correction, it will continue its movement to the
previous direction. The main nicety here is to distinguish one pattern from
another and it should be done as soon as possible, during its forming.
Let us consider the reversal pattern first.
Before proceeding to detailed consideration of
every major reversal pattern, let us point out some general conditions which
are typical for any of these patterns:
- Prerequisite for the appearance of any reversal pattern is the previous trend
- The first signal of coming fracture often can be break of the important trend line.
- The larger a pattern then more important will be future market movement.
- Top patterns as a rule are more changeable and short in time than bottom patterns.
- Bottom patterns are characterized by less price change and it takes more time for its modelling.
REVERSAL PATTERN “HEAD-AND-SHOULDERS”
Now we are going to dwell upon the most famous and
reliable pattern – “head-and-shoulders”
pattern. We will pay attention to this pattern not only because it is very
important indeed, but also in order to consider all possible nuances connected
with reversal pattern analysis. The matter is that most other reversal
patterns are just variants of the “head-and-shoulders” model and do not need such
detailed consideration.
This main reversal pattern as others is a direct
logical continuation and development of the points connected with the trend, which
we talk about in the last lesson. Imagine the situation where while uptrend
consecutively rising highs and downsides are gradually started to slow pace.
As a result, stagnation appears in uptrend dynamics. At the moment the forces of
supply and demand are considered in balance. When this phase ends, the support
level which undergoes along with the horizontal “trading range,” breaks. At this
moment downtrend starts. Consequently, it is formed by descending highs and
downsides.
Let us consider now how the reversal scenario will look
at the peak of the market, presented by the pattern “head-and-shoulders” (pic. 1 and 2). In A point uptrend continues its development without any
insinuation to the top. Prices form new maximum, volume is increasing. Everything
is like it should be.
Then intermediate downside occurs (point B). In C point
accurate analyst notices that trading activeness was lower than in previous
uptrend period while price break above A level. This event does not have any
importance on its own but an alert signal appears in the analyst’s mind. Prices start
falling down after that till D point and then something more serious occurs.
Prices fail to take out the previous peak in A point. Let us remember that while uptrend every previous peak
should be a support level relative to the intermediate downsides. It does not
happen in our case. Prices fall down the A point almost to the level of
previous downsides (point B). It is one more alarm: seems like the uptrend is
weakened.
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| Pic 1 |
Pic. 1. Pattern example for a market top. Left and right shoulders (A and E) is almost at the same level. Head (C ) is higher than any shoulder. The pattern is completed when the closing price is fixed below the level of the neckline (line2).
The neckline is built from point B – the first downside of pattern formation, through D point – the second downside.
Minimal target can be calculated by measuring the high point
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| Pic 2 |
INVERSE HEAD-AND-SHOULDERS PATTERN
Price targets assessment is made with the
same principles as for top patterns. The insignificant distinction is that the probability of reverse price movement to the neckline after the bullish break is
higher in the bottom pattern.
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| Pic 3 |
The difference here is that market can “fall down”
because of inertial force. Demand and purchase requirement absence is enough to
urge the market down. However, it is impossible to make it move upwards by
inertia force. Prices will grow only if demand exceeds supply if buyers are
more active and energetic than sellers.
Price rise from the head point in the bottom the pattern should be followed by the increase of business activity but often its level
exceeds the volume which falls on the previous spike from the left shoulders
point. Slope to the right shoulder
should lead to volume decrease.
The most critical moment falls on the breakpoint of
the neckline. This signal should be attended to by the real explosion of traffic
if the break is not false. It is the main difference between the top pattern
and inverse pattern, or the bottom pattern.
For the last pattern large traffic
while the closing is an absolutely necessary component. Reverse price movement is more
typical for the bottom pattern and should be followed by little trading volume.
However while the next restoration of the steady uptrend, the volume should rise.
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| Pic 4 |
For positions opening in the top pattern or in the bottom
one, it is necessary to wait until the neckline break. Only after the break of
this support or resistance line, the pattern is complete. After prices cross the
neckline and finished the formation of the head-and-shoulders pattern, they should not cross the neckline again.
If
we have the top pattern then after the neckline was broken down, any following
price closing above the neckline is a serious warning that the first break was
false. Failed head-and-shoulders patterns appear.
In the beginning, these
patterns look like a classic reversal pattern and then at some development
level (before the neckline break or after it) prices suddenly start moving in the previous trend.
TRIPLE TOP AND TRIPLE BOTTOM
Many conditions which we were talking about while
head-and-shoulders pattern discussion, can be referred to as other reversal
patterns (pic.5). Triple top and the bottom
pattern is rarer than head-and-shoulders. Triple top and the bottom pattern is
just a variety of it.
The main difference is that all three peaks (or slope) are
at the same level in the triple top and bottom pattern (pic. 7). Technical
analysts often disagree on what they see: head-and-shoulders or triple top.
This argument has mostly academic character because both patterns present
almost the same.
Trading volume decreases along with every following
peak in the top pattern and should increase in the breakpoint. The pattern is not
complete until the support levels passing under two previous slopes are not
broken.
Consequently closing prices should break resistance level passing above
the previous two peaks. Only after a pattern is complete (as an alternative strategy
you can consider the closest peak or slope level break as a signal of trend reverse). A very important factor for completing the bottom pattern is trading volume
increase.
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| Pic 5 |
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| Pic 6 |
Pic. 6. Triple top of a reversal pattern. Pay attention to the three peaks formed in June. Take notice of how the support level turns into a resistance level after the breakdown.
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| Pic 7 |
Pic. 7 Triple bottoms. It is analogous to inverse head-and-shoulders pattern with an exception of all three slopes is at the same level. It is a mirror reflection of the triple top model with the only difference of volume as a confirmative factor being more important while the break upwards.
DOUBLE TOP AND DOUBLE BOTTOM
This reversal pattern is more widespread than the
previous one. It is the most familiar after the head-and-shoulders model (pic.
8). In pictures 8 and 1 0 top and
bottom pattern are drawn. Pay attention that the double top model resembles the letter
“M” by contour and the double bottom resembles the “W” letter.
They are called this
way often. General characteristics of the double pattern agree with
characteristics of the head-and-shoulders pattern and triple top with an exception
of two peaks instead of three. Volume changes led to the double top formation,
and the way of its assessment are similar to those we considered above.
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| Pic 8 |
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| Pic 9 |
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| Pic. |
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| Pic. |
Pic. 1 1 .Example
of the double bottom pattern. Pay attention to the sharp delineated double bottom.
When closing prices broke through the pullback level pattern was complete and
reverse to the uptrend occurred. Back motion confirmed the conversion of resistance
level to support level which gave a strong signal to the opening of the long position.
As it was mentioned above all these models are just
variants of the head-and-shoulders pattern so the trading tactic is similar - long and short positions opening is
executing only after breaking through the neckline, when the pattern is completed.
The strongest signal confirming pattern formation completion, and defining the
moment of positions opening is rebound from the neckline after testing it as a
result of backwards motion. Now let us dwell upon the notion of price guidepost which was mentioned
during the lesson. There is a method of price levels assessment that is
reached by the market after the formation of these models is completed.
This method is based on the height of the model. So let us measure the height from the maximal
point of the head to the neckline. Then protract the found length down from the
breakthrough point of the neckline. Let us suppose that the peak point of the head
is at level 1 00, and the
neckline is at level 80.
Consequently, the length of the segment will be equal
to their difference, i.e. 20. Let us protract 20 pips downwards from the breakthrough point of the neckline and we get the minimum price guidepost where the
market will come, it will be level 60. This method is universal for all
considered patterns (it is taken the middle point between two peaks or slopes
to the neckline).
V-SHAPED PATTERNS OR SPIKES
The last reversal pattern which we will talk about
is characterized by the difficulty of its recognition in the period of formation
but it occurs often. In fact, V-shaped top or bottom (they are also called
spikes) are hardly recognizable because they are not patterns in every sense of
the word.
All the models we were learning before, reflect gradual changes in
trend dynamics. Prices are vacillating some time in the framework of horizontal
trading “corridor”. An analyst can examine market dynamics in this period, make a
forecast about its future, try to find some tips in past or present.
Almost all
the reversal patterns form by this scenario. All models except V-shaped
ones. There is no hint of gradual change in trend dynamics. The turning point of
trend occurs quickly, often without any warning signal. This fracture is
followed by sudden and very fast price movement in opposite direction.
The V-shaped pattern can be hardly called a model because estimate it or understand that it
really took place, we can only post factum. So what should a trader do? How can
he foresee such models, recognize them information process and take measures?
To answer all this question let us first examine the V-shaped top pattern (pic. 1 2)
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| Pic. |
First of all, we have a previous trend. Often V-shaped fracture precedes by the swift market development, there is no intermediate corrections or only insignificant. As a rule, there are several price gaps in the dynamic of such a trend.
t seems like the market situation goes out of control, the market overcomes all the possible and impossible expectations. Here experienced
know: here he should keep his eyes open.
The main precondition for V-shape reversal or spike
is having a steep or swift trend.
Sometimes the only signal pointed upon the trend reversal is
breakthrough the unusual swift trend.
Falling following after the reversal reflects, as a rule, the previous uptrend (one third or 50 %), and it occurs for a
short period of time. The main reason for sudden movement to the opposite side
is the absence of support and resistance levels of the previous trend (because it does
not have intermediate adjustments). V-shaped models appear on top as well as
on the bottom of the market, the brightest examples are character for the top.
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Pic. |
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| Pic. |
We considered the most widespread major reversal patterns: head-and-shoulders pattern, double and triple tops and bottoms and V-shaped pattern, or spike. As a rule, these patterns give a signal about the fracture of existing trend formation. That is why they are called “major reversal patterns”.
However, there is one more set of models which are briefer
by nature and indicates not about the reversal trend but about consolidation.
And their name is continuation
pattern”.
Continuation patterns
Graphical configurations which we will be
considering, are called continuation
patterns. Such models usually mean that period of price stagnation
reflected in the chart, is not more than a pause in the trend development and
trend direction will be the same after their completion. This is the major
difference between the reversal patterns, which reflect the fracture of the
main trend, and continuation ones.
Another criterion of difference between the
reversal and continuation models is the duration of their formation. More time is
spent on the formation of the first patterns which show cardinal changes in
price dynamics. Continuation models are short-term patterns. They should be
correctly called intermediate.
TRIANGLES
Let us start with triangles consideration. There
are three types of triangles: symmetrical, ascending and descending. All of
them are different in shape and have different forecasting functions.
One moment should be underlined that often
triangles are the last correcting formation which precedes the cardinal top or
bottom completing the trend. While this model forming you should carefully
estimate the chart for the possibility of the main trend end approaching.
The main varieties of this pattern are shown in the
pic. 1 a-c. An asymmetrical triangle
(pic.1 a) is formed of two convergent
trend lines where the top line is going down and the bottom line is going up.
A vertical line from the left, which determines the
height of the model is called a base.
The cross point of two lines from the right is called the apex. The symmetrical triangle is also called a spiral for simple reasons.
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| Pic. |
Pic.
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| Pic. |
Descending triangle (pic. 1 c),
on the contrary, has a horizontal bottom and falling top lines.
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| Pic. |
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| Pic. |
Triangle formation signifies the pause in the
present trend, after which the last one is renewing. For instance, at the pic. 1 a the previous trend was ascending and after the
price consolidation in the shape of a triangle, their development will
continue. In the case of descending trend symmetrical triangle would signify that
after its completion, price falling will be resumed.
The minimum requirement for
every triangle is the presence of four-point of control. For drawing the trendline
as we remember it is necessary to have 2 points. So to draw two convergent
trend lines each of them should go at least through the two points. At the
pic.
Pay attention to the fact that point 4 is higher
than point 2. The lower ascending line can be drawn only when the prices will go up
from point 4 in
the course of market animation. Only after this moment analyst understands that
it is a symmetrical triangle. Now we have four points of control (1 , 2, 3, 4) and two convergent trendlines.
The signal of pattern completion is given when the
closing price coming out of one of the trendlines. Sometimes backstroke of the prices to the trendline is observed after the
breakthrough. Depending on the trend direction – ascending or descending - this line becomes support or resistance
level.
After the breakthrough, the top serves as an important support or
resistance level. Criteria of the intersection while the breakthrough can be
different, in these cases minimal criterion of intersection is closing price fixed
out the bounds of the trendline but not the simple intraday intersection.
Trading rules are the same for all the triangles.
It is better not to trade upon the insignificant fluctuation inside the
triangle, of course, if this triangle is small. As the triangle is older price fluctuations become fewer.
Profit is
decreasing, and shift and commissions are continuing to eat your balance as
before. That is why the best variant is to buy or sell while the breakthrough
upwards and downwards of triangle trendline in direction of the main trend.
Stop-losses should be placed upper or lower of the breaking trendline.
There is a method allowing determining the price
guideposts which market will reach after the triangle completion.
The way of determination is rather simple. Measure
the height of the model in the widest part and project this distance upward or
downward (depending on the direction of the trend). The level derived as a result
of projection will be the point of price guidepost.
FLAG AND PENNON
Flag and pennon
are very widespread on charts of the financial market. They are being considered
together because of their similarity. These configurations form at one and the
same area of trend development, they have the same indicators of trading volume
and their determination is also similar.
Flag and pennon
signify the short pauses in dynamically developing trend. A steep line of price
movement should precede the formation of these models on the chart. They designate the
markets which outrun themselves in their development upwards or downwards and
should stop for a while before they start moving in the same direction.
Flags and pennons are the most reliable patterns of
continuation trend. Reversal trend occurs seldom in these patterns. Look at the
example (pic.2) and see how similar these models are.
Pay attention to the
quick price rising with a big volume, preceding the model formation, and also
swift activity decrease during its formation which gives a signal about the
market consolidation. Then activity is quickly increasing after the top
trendline breakthrough.
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| Pic. 2 |
The formation of these two models is almost the same. The flag reminds the parallelogram or rectangle limited by two parallel trendlines
with an incline to the opposite side of the dominant trend.
In a downtrend, the flag should
be directed upward a little. Pennon model can be determined by two convergent
trendlines and more horizontal position. Pennon reminds a small symmetrical
triangle but differs by the scale: if the triangle is forming by several swings of
chart movement, then for pennon formation several candlesticks are needed, which
form a little triangle. Flag forms by several candlesticks placed parallel in the shape of oblong width.
Both models are rather short-term. While the
downtrend needs less time to form than while the uptrend. Completing of
both models occurs while the crossing of the upper trendline during the
uptrend. Breakthrough of bottom trendline indicates the downtrend resumption.
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| Pic.3 |
Sharp foregoing pulse is obligatory for flags and
pennons’ formation; it makes some “flagstaff” which the models stand upon.
There are also ways of price guideposts
determination exist, which will be reached when the model is completed.
Ways of determination for both patterns are
similar. Flag and pennon models like “fly up from the flagstaff to the middle
of the mast”. It means flag or pennon are placed in the middle of price rising
or falling.
In aggressive trading, the trader takes all the distance
which price exceeded before a model formation as a guideline, and in a careful
trading 50% of the distance is taken.
Opening positions is recommended after the process
of pattern, formation is completed, after the breakthrough of trendline limited
the body of the model, in the direction of the main trend.