Chart Patterns Master Series Copyright 2008 Mark Deaton
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Table of Contents
Introduction 2
Megaphone or Broadening Bottom 3
Megaphone or Broadening Top 6
Cup and Handle 9
Dead Cat Bounce 12
Diamond Tops and Bottoms 15
Double Tops and Bottoms 18
Triple Tops and Bottoms 22
Flags and Pennants 25
Head and Shoulders 28
Island Reversals 31 Ascending Triangles 34 Descending Triangles 37 Ascending Wedges 40 Descending Wedges 43 Conclusion 46
Introduction
The theory of garnering profits through investments is easy to comprehend. Buy when prices are rising. Sell when they are falling. As everyone knows, however, prices just do not move
steadily in one direction. They are volatile. The key to successful investing is, thus, being able to accurately determine whether the investment vehicle chosen for the time period in question will increase or decrease in price. Proper chart analysis is the methodology that will allow anyone to become a successful investor.
For the astute investor, price charts are not just random movements depicted graphically. Proper recognition of the patterns that they form over time is the signals of where market participants are investing their money. If an investor can recognize these signals as they appear, it becomes a simple and self-evident exercise as to whether to buy (go long) or sell (go short) the investment under consideration.
The price of a holding, whether it be the shares of IBM, crude oil, Japanese yen, or treasury bonds, will move based on the laws of supply and demand. When there are more buyers than sellers, the price will rise. When there are more sellers and buyers, the price falls.
One classic investment methodology is called fundamental analysis. Basically, this technique attempts to look at all the factors that affect a particular investment under consideration, and based on an analysis of those factors, determine whether the likely demand for that investment will increase, stay steady, or fall. Once this analysis has been accomplished, the investor takes the appropriate position.
In contrast to fundamental analysis are techniques referred to generally as technical analysis. The principles behind this methodology maintain that markets are in essence efficient, and they trend over time. This being the case, all the successful investor needs is to be able to recognize the repetitive patterns that develop in a chart in order to make proper investment decisions. Fundamental analysis becomes irrelevant because the price of an investment already reflects all the available information in the market.
Whether an investor chooses to use technical analysis or fundamental analysis in his or her trading decision is a personal matter. It never hurts to be aware of all the tools available in making investment placements. Anyone familiar with markets knows chart patterns are actively used by the investment community. All brokerages supply investors with a plethora of
information concerning charts to help their clients in making their decisions. Tens of thousands of analysts across the globe issue recommendations based on their interpretations of chart patterns. It would be foolish for any serious investor, no matter what type of market he or she is interested in, not to have knowledge of chart patterns and their importance to price movement. This book gives the reader the tools to identify the signals that chart patterns produce, with the goal of predicting with accuracy the direction of future price movement, the probable intensity of the direction, and the reliability of the movement. The information presented herein, when properly utilized, can greatly increase the wealth of any investor.
Megaphone or Broadening Bottom
A megaphone and broadening bottom formation on a price chart is generally regarded as a bullish signal. It signifies that the current downtrend is probably going to reverse itself, and then establish a new uptrend movement. This type of formation is characterized by successfully lower lows and higher highs which accumulate during an overall downward trend. For the proper formation to be recognized, there must be at least two higher highs situated between three lower lows. The chart pattern is considered complete when prices rise above the second higher high and do not return below it. This usually occurs during the third upswing during the formation of the pattern.
Source: http://www.marketscreen.com/help/chartpatterns/default.asp?hideHF=&Num=103
Performance
Though considered a bullish formation, broadening bottoms that have downside breakouts can actually outperform those on the upside. Consequently, for the investor, this type of formation produces an opportunity both for a long and short position depending which way a breakout occurs. Statistical analyses of these types of formations tend to indicate that bullish breakouts will result in a significant move upwards from the point of breakout, as will downward breakouts on the downside. These formations appear to be remarkably accurate indicators, with some studies reporting as high as a 98% success rate of continued price appreciation when an upward breakout occurs. On the downside, the accuracy has been reported as high as 94%.
In recognizing a broadening bottom formation, the two trend lines drawn across the intermediate highs and lows are very important. These trend lines should slope in opposite directions. In other words, the trend lines based on the intermittent highs should be rising upwards, and the one based on the lows should be headed downwards. This is the distinguishing aspect of a
megaphone or broadening bottom chart pattern.
Another one of the distinguishing aspects of this formation is that volume follows price. That is, between peaks and troughs, there should be a visibly declining volume of activity. The opposite should also hold true, from the intermediate lows to high. The point of entry when using such a formation as a signal should be a clear point above or below the trend lines that have been made. If prices clearly extend beyond or below the trend line, then that penetration point is the breakout point of the formation and represents the consideration price that needs to be exceeded for a position to be undertaken.
The average time needed for the formation of this sort of chart pattern is about two months. It should be kept in consideration that this is the average, and the actual range can be significantly shorter or longer. The varying movements necessitated for the proper formation to occur require a significant amount of time to pass.
Trading Considerations
As these types of formations are so highly successful based on statistical regression analysis and their failure rate is so low, it is difficult to formulate a defensive strategy for those rare instances when they represent false signals. Generally speaking, however, if a breakout occurs in prices and then fails to move more than 5% in the desired direction before returning to the breakout point, positions should be liquidated.
Megaphone bottoms that produce upside breakouts can be generally considered as reversals of the underlying downward trend. On the other hand, those that produce downside breakouts should be considered consolidations. This logically makes sense as these formations can only be recognized as such after a distinct previous downward trend has been identified.
The failure rate of these formations is exceptionally low. If one is to give consideration as to how they are formed, this actually makes sense. Breakouts occur, as can be seen from any chart, at the widest point of the broadening formation. This means than an intermediate strong trend has already established itself on one side of the formation to the other. A large amount of momentum has actually been established, such that when a breakout occurs, prices are moving along in the direction of the least resistance.
When trading a megaphone or broadening bottom formation, it is important to try to determine the likely price move that will occur once the formation is broken. Generally speaking, the best tactic to use is to subtract the lowest low from the highest high recorded during the formation of this chart sequence. This will give a measure of depth of range. This depth measure should be added to the highest high in order to obtain a target price after an upside breakout. Similarly, it should be subtracted from the lowest low for the short side target price upon a downside
not always be achieved; consequently, conservative investors may find it wise to have profitable exit points determined somewhat before the achievement of target prices.
Regardless of what profit goals are established, every investor must be prepared for an unsuccessful trade. As a result, it is recommended to have a stop loss order placed at a level 20% below the minor low or high as has been exhibited in the formation. Using this strategy, the investor will only have a minor loss should a formation failure occur. For those aggressive traders, who want to hope that they have stumbled upon a major reversal or continuation pattern, they can continuously adjust their stops to the successive intermittent minor highs or lows that occur during the major move that they have discovered.
Broadening bottom megaphone chart formations have been widely statistically analyzed by trading professionals. The results of these studies all indicate that these types of chart patterns can be exceptionally successful in predicting future movements, either on the upside or the downside. For the individual investor, these patterns, if they can be properly recognized,
represents a remarkable tool for successful and profitable results in the investment markets. The data tends to suggest that the breakage of this formation is an exceptional signal for continued movement in the direction of the breakout, regardless of the type of market: stocks, foreign exchange, commodities, etc. As it is generally considered a rare occurrence, when it does happen, the knowledgeable investor will use it to his or her advantage.
Megaphone or Broadening Tops
Broadening or megaphone tops can be considered the opposite of broadening bottoms, and these formations signals act very much the same. What differentiates the top and bottom formations is the trend that has been established before the pattern arises. For megaphone tops, the price trend has been clearly upwards, while those for bottoms the opposite holds true. The directional differences are not the only distinction. These formations may act similarly, but their performance results differ.
Statistical Evidence
There are basically two types of broadening top chart patterns for the investor: one that produces an upside breakout, and the other which produces a downside breakout. As with broadening bottoms, statistically, these types of breakout signals can result in subsequent significant price movement in the direction of the breakout as high as 96% of the time, according to certain
studies. Some research has demonstrated up side price movement averages as high as 34%, with down side breakouts averaging around 23%. Given these statistical results, these types of
formations represent an exceptional tool for the investor in order to make investment decisions. Formation Characteristics
There are many different recognized variations of these broadening formations. The characteristics of this general chart pattern are always the same. For a true megaphone top formation to exist, there must be a distinct precedent uptrend that can be seen in the chart. When trend lines connect the intermittent highs and lows, what results should be a visualization that resembles a megaphone. It is the previous lower lows and higher highs that make this pattern obvious for the investor. The slopes of the resultant trend lines distinguish this pattern from other similar, but different formations. The trend line created by connecting the intermittent highs must always be sloping upwards, while the one connecting intermittent lows must clearly have a downward direction. If one of these trend lines is somewhat horizontal, or they both slope in the same direction, then the formation cannot be considered a broadening top.
At a minimum, there must be at least two minor lows and two minor highs before the pattern can be considered to be a proper formation. These price highs and lows must be clearly distinctive within the charted range as per the example below.
Source: http://www.thestreet.com/p/_rms/rmoney/technicalanalysis/10269434.html
Linear regressions statistical studies have shown that during the formation of these types of patterns, volume tends to follow the price movement being exhibited within the formation. Consequently, when prices are rising, the volume of activity also tends to be rising. The reverse is true in the opposite direction.
The point of interest for investors is that the breakout points that occur signal the formation has ended and a significant price move should be anticipated in the direction of the breakout. Breakouts are the prices above and below the two trend lines that have been formed by connecting the relative highs and lows within the formation that produced the image of the megaphone. What is distinctive about this formation is that it can be clearly seen that during its consolidating phase, every time the price has approached the identified trend lines, it retreats to within the previous range. As a result, when it finally pierces one of the trend lines, it becomes a very strong historical signal that the directional move established will continue significantly into the future.
Trading Considerations
The proper interpretive significance of this formation is dependent upon the direction of the breakout. When breakouts have occurred on the upside, the formation was in essence a
consolidation, and the established uptrend will continue. Breakouts on the downside, however, represent the signaling that a reversal has occurred. Many analysts consider the formation of a megaphone top chart pattern to be a bearish indication. Statistical research, however, is inconclusive in its findings.
From a tactical perspective in making decisions towards anticipated price movements, the general rule of thumb is to take the largest range exhibited within a broadening top formation,
and then add it to the previous highest high exhibited, in order to obtain an anticipated target price. When the breakout occurred on the downside, this range figure is subtracted from the lowest previous low exhibited for a similar target assessment price.
Though these types of formations have been shown to be exceptionally accurate in predicting future movements in the direction of the breakouts, every investor must be prepared for a failure, even though its occurrence appears to be exceptionally rare. The generally accepted
methodology is to have a stop loss a certain percentage below the previous relative high in an upwards breakout, and above the previous relative low in a downward break. As these types of formations can be the first indication of a significant reversal of trend, if this were to occur, and an investor has taken the proper position, it is highly advisable to adjust the stop loss order to subsequent exhibited relative highs and lows so as to maximize the benefit from having entered the trend reversal at the very beginning.
Broadening or megaphone tops represent an exceptional tool for the trader to make proper investment decisions that will culminate in successful results. These patterns, unlike most consolidation formations, are characterized by ever-increasing tops and bottoms resulting from increased volatility in price ranges with the passage of time. Volume can be seen to be
increasing significantly during intermittent price rises and falling during intermittent reversals. Since the bullish signals produced by the rallies are evidently short lived, when a reversal breakout occurs, more often than not, it is the beginning of a significant downward movement that can prove to be long-term, and, thus, representing a truly extraordinary investment
opportunity. Broadening top formations that have occurred after an exceptionally long previous uptrend signify that speculators have produced unrealistic expectations; as a result, the reversal will usually result in an extremely significant correction. Traders who can properly identify a broadening top megaphone chart pattern can be expected to obtain extraordinary trading results upon implementation of the proper position.
Cup and Handle
The cup and handle chart pattern is generally regarded as a bullish continuation pattern that represents a significantly long consolidation, followed by a breakout upwards. It is attributed to William O'Neil and was first introduced in his book called "How to Make Money in Stocks." As the name implies, the cup and handle formation resembles a tea cup on the chart. The length of time necessary for the pattern to form can vary from several months to a year. The general form, however, is always the same. It shows a distinct curve continuation pattern, at the end of which the established upward trend stalls and prices move downward to form the handle. When the handle pattern has been penetrated upward, it is usually followed by a significant
appreciation of price.
Source:
http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:cup_with _handle
Formation
This type of chart pattern is characterized by a distinct upward move, which then stops and sells off. This selloff is the critical part of this pattern formation. Once it has occurred, the market in question basically trades in a relatively narrow range downward for an extended period of time and demonstrates no clear trending movement. Once this has occurred, the price moves back up towards the previous high. The trading range during this period can be seen forming a distinct
handle formation relative to the large cup base of the preceding trading time period. Once this handle formation is broken, the market moves distinctly higher and continues the previous upward trend.
Generally, analysts confirm the formation of a cup and handle chart pattern by demanding a minimum 30 percent increase from the low point in the cup before it the formation of the handle. In addition, there must be a period of very high volume somewhere during the rise and creation of the cup. All the cups must have a distinctive U-shaped base with a handle, so as to distinguish it from a simple rounding bottom formation. In addition, the handle should have a minimum one to two weeks duration period.
There are several aspects of this sort of chart pattern that should be noted in order to best to evaluate its potential as a trading signal. It is critical in this type of pattern to note what type of price movement occurred prior to the formation of the cup and handle. As a general rule, the larger the prior rise was before the appearance of a cup and handle chart pattern, the lower the probability for a significant breakout once the pattern has been completed. As there has already been a significant price appreciation prior to the formation of the current pattern, this weakens the momentum of the price movement for a continued upward appreciation.
Trading Strategies
Strategies for determining the upward price potential usually entail determining the height of formation from the lowest low that exists in the cup to the high produced at the cup lip on the right-hand side. Adding this differential to that high produces the target price. However, statistical studies show this methodology has never produced a success rate of over 50%. This means that less than half the breakouts reach this level. The smaller the percentage taken of this previous range exhibited in the cup, the larger the likelihood of achieving that
price-performance. Consequently, when trading this formation, one should look for extended depths within the cup, and then take a relatively modest percentage price goal in order to maximize trading results and performance.
This chart formation lacks the statistical certainties of other formations. It is also characterized as being difficult to truly objectively recognize. Investors do look for this type of pattern, nonetheless, and there are certain techniques that can be used to improve the likelihood of undertaking a successful investment. Often, when this pattern materializes, a breakout occurs from the handle above the right cup lip’s previous high, and the price will increase but then come back to the lip high price. When this occurs, it tends to act as a confirmation that the upward trend will resume. Waiting for this confirmation, and only entering after the prices return to the upper lip before taking on a long position, greatly improves the probability of a successful trade. As with any chart pattern, one should always be prepared for formation failure. With this particular type of pattern stop loss, orders are placed somewhere below the handle low in order to minimize losses. The rule of thumb is generally the place stops at 12 1/2 percent below this price, as the handle becomes a support level for corrective retracements. Consequently, an investor would want to see a distinct penetration of that support level, prior to recognition of a loss. In order to take advantage of the upward movement, it would be beneficial to have a moving stop 12 1/2 percent below clearly defined support levels, so as to maximize potential
future profits. This tactic will eventually force you into a profit, but protect you from a potential reversal that would eliminate entirely any possibility of a successful result.
As with almost all chart patterns, volume of trading activity is a useful confirmation for implementing a position when a signal is recognized. The cup and handle formation is no exception. Generally speaking, the larger the volume on the upward breakout, the higher the probability that the upward trend will resume and continue.
The cup and handle is just one of many successful chart formations used by investors to obtain gains from trading. The difficulty in using this chart pattern is its recognition, which can only occur through time-tested practice.
Dead Cat Bounce
Within investment circles, there is an adage that says even a dead can bounce if it falls from a tall enough height. The dead cat bounce chart pattern concerns a short term recovery in an
overwhelming downward trending market.
Whenever a price has moved significantly over a long period of time in one direction, investors will start to rethink about whether they are holding the proper positions. After such movements, those who were lucky enough to have recognized the trend from an early point are closing out their positions in order to recognize some profits. At the same time, especially in a bear market, certain value oriented investors are beginning to believe the bottom has been reached, and that it may be appropriate to take a long position. The final type of trader to enter in this scenario is one who will use a strategy based on momentum, and looks at his or her particular trading
signals to try to identify an oversold market. All of these influences bring on a certain amount of buying sentiment, if only but for a brief period of time, which sends the market up. It is in situations like this that the dead cat bounce chart pattern appears.
Formation
A dead cat bounce chart formation is often characterized by a gapped down trading session. Some sort of news event happens that is so surprising to market participants that sell orders completely overwhelm what little buying demand there is. The price declines and opens at a much lower level. In addition, volume is exceptionally strong relative to what turnover was traditionally. It is not uncommon to see 20 times or more normal trading levels. After this, a bounce consolidation phase begins. The price starts to recuperate some of its losses. This recuperation, however, is usually short-lived, and the downward trend shortly thereafter continues.
Source:
http://www.mrswing.com/artman/publish/SwingTracker_stock_scan_/Trading_Dead_Cat_Bounc e.shtml
Not all significant downward trends result in a dead cat bounce. However, statistical studies tend to show, 90% of the time this formation appears, there is an additional significant downward movement. The average decline, as measured from the high the day before the price gapped downward, to the ultimate low achieved subsequently, ranges as a decline in the 30 to 40% range. The average recovery tends to be in the 20 to 30% range from the low register on the bounce day.
Trading Strategies
From a trading perspective, the best way to profit from a dead cat bounce is to wait for a recovery high enough in order to take a short position. Generally, the percentage fall from that recovery high to the ultimate low ranges between 15 and 25%, a large enough fall in order to risk a trade. Based on historical studies, the recovery high should occur within two weeks of the appearance of the bounce. An appropriate position price should be determined at which the sell order should be placed. Trading dead cat bounces can be risky, however, as they have occurred because there has already been an extremely severe decline. As it is a high percentage trade, there is the possibility for low risk, short-term profit.
However, dead cat bounces can statistically be shown to be low risk trading opportunities. They do not represent a situation for an investor to obtain a large successful gain. As the saying goes, you can throw a dead cat off from a high enough point and it will bounce. The bounce, however, will not be very high and the cat will still be dead.
The primary attractiveness with this sort of chart pattern is that it represents an opportunity for an astute investor to make a quick small profit. The problem with this type of formation is the fact there has been an already tremendous deterioration and fall in price when it appears. As a result, the profit potentials for a trader are extremely limited. Consequently, care should be taken when considering entering trades because of the inherent background of this chart pattern. Though they represent opportunities, they can at times be precursors to a significant trend reversal. Therefore, whenever considering entering a position at the occurrence of a dead cat bounce, proper stop loss orders should also be in place. Any reversal in price to the high of the day previous to the gap down is an almost guaranteed signal that the pattern has failed. Should this occur and the investor is in a short position, losses should be terminated at this point.
If an investor wants to trade a dead cat bounce, the odds are in his favor in producing a successful result, if he or she is not too greedy. It is highly recommended that when
contemplating this sort of chart formation that the gap that has occurred be at least 20% of the previous day’s range, and that volume on the gap day is at least three to four times the recent daily average. In order to maximize profitability, a price needs to be determined on a subsequent bounce as an entry point. This bounce should occur in a relatively short period of time. If it hasn't materialized within two weeks, then there is no dead cat bounce. The continuation of the downtrend after the appearance of the bounce should last between three to six months. However, the further decline will be modest, but almost guaranteed. Where the dead cat bounce occurs relative to the historical price performance will determine the magnitude of the further decline.
If the drop precedent to the appearance of a dead cat bounce chart formation happens after the appearance of a previous long term high, then the continuation of the fall after the bounce will be greater and the failure rate much less likely.
It cannot be emphasized enough, however, that this particular chart formation only occurs after a dramatic fall in the price of a market has happened. At some point in time, every investment will begin to look cheap. And as the fundamentals of any successful investment strategy is to buy low and sell high, one should take particular care in utilizing the dead cat bounce chart pattern as an investment indicator.
Diamond Tops and Bottoms
The only difference between a diamond top and a diamond bottom during the formation of these types of chart patterns result from the price trend that precedes the formation. Diamond top chart patterns are preceded by an upward trend, while diamond bottoms have declining prices prior to appearance.
Performance results of these types of chart formations are similar. Both serve as signals that the precedent prevailing price movements are about to reverse themselves when a breakout occurs on high volume. The historical studies done on this chart pattern seem to demonstrate a failure rate of approximately 25% for diamond tops, which is roughly twice the rate for diamond bottoms. As this failure rate is relatively high for diamond tops, using them as a signal for position taking purposes may not be well advised, unless they occur in conjunction with another indicator. When breakout occurs, the average declines appear to be around 20% for top
formations, whereas the average rise from diamond bottom chart patterns upon breakout is in the 35% range.
Source:
http://www.baresearch.com/education/technical_analysis/chart_patterns/reversal/diamonds.phpF
For the formation of a diamond top chart pattern to occur, there must be an upward short-term price movement that leads to a minor high on the left side of the formation. Price is then expected to proceed to decline, in order to form a minor low, before turning around and moving higher again. They then reach a new high before tumbling down again to finish below the previous minor low. Once again, prices begin to rise, reaching another minor high before breaking down and penetrating the upward trend line on the right. These fluctuations that produce the relatively minor highs and lows will result in a diamond shaped formation when the
various relative high and low prices are connected. It should be noted that the formation does not necessarily need to be symmetrical, as irregular diamond chart patterns are very common. Volume tends to be declining, especially during the latter part of the formation of this type of chart pattern, when the price range begins to narrow. When breakout occurs, trading volume is usually higher than normal, but this is not a prerequisite for this pattern. Generally speaking, however, these types of chart patterns are characterize by the right side volume being much lower when compared to the volume of trade on the left side.
The formation of a diamond top chart pattern is considered a bearish signal. When breakout occurs on the downside, there is an excellent potential for a short sale with a profitable result. Support and resistance levels for diamond tops normally appear at the top of the formation. Diamond bottom formations are similar to those of tops, but in reverse. There is a clear precedent downward trend in prices prior to the appearance of the chart pattern. After this downward trend price has rebounded slightly, the range starts to expand, producing higher highs and lower lows. The price trend then begins to narrow with resulting higher lows following lower highs. The diamond formation then becomes evident when trend lines are drawn connecting the various limits of the price movements. Volume during the formation tends to recede, but this is not mandatory for diamond bottoms. As is characteristic in tops, there can be wide variations in volumes traded. Overall, nonetheless, volume tends to reduce overtime until the point of breakout, where volume is usually significantly higher.
Trading Strategies
As with any chart pattern formation, target prices need to be developed. With diamond tops and bottoms, the rule of thumb is to locate the highest high and lowest low in the formation and subtract the low from the high. This is normally considered the minimum price move to be expected upon breakout. Historical studies seem to indicate that these distances will be traversed 95% of the time when the breakout occurs from a diamond bottom and 79% of the time when the breakout occurs from a diamond top. Given this historical precedent, the use of this sort of methodology for achieving your profit goals when instituting a trade is highly recommended. Diamond top and bottom chart patterns form relatively infrequently on price charts. When they do occur, however, it appears that they do so more frequently at market tops rather than market bottoms. This appears to be quite logical and consistent with the shape of this type of formation, which appears to suggest an indecisive market, where one would expect more often after a strong bull run. Volume activity is extremely important in identifying a diamond formation and in helping not to confuse it with a typical head and shoulders pattern. This confusion can arise because of the upward sloping neckline in these patterns, which also can be used as an early entry point for the position, and therefore, result in a greater profit. Genuine diamond chart formations are always identified by decreasing volume during the second part of the price pattern.
When breakouts occur from a diamond formation, they are almost immediately followed by a two to three percent movement in the direction of the breakout. What usually follows next is a return to that breakout level. If the price is for any reason is not supported at this point, and there is a retracement above or below depending on the type of breakout, the pattern must be
considered invalid. Consequently, stop loss orders should be placed at these levels so as to minimize losses due to a formation failure.
Diamond top and bottom chart patterns are extremely difficult to identify as they have characteristics that are very similar to other technical analysis chart formations. The
distinguishing aspects of the diamond formation that the investor needs to master to properly identify are the upper and lower trading range and the volume behavior within the pattern. True diamond patterns are exceptionally rare; however, for the investor who has mastered their recognition, they represent an outstanding trading tool, since when breakouts occur, subsequent movements tend to be very substantial. Therefore, profit potentials are excellent.
Double Tops and Bottoms
A double top chart pattern is defined as the formation that occurs when the price has risen to a certain level and then drops back from that point, only to return to that same level and drop back off once again. A double bottom chart pattern is, in essence, the exact opposite of a double top. This bottom formation occurs when prices decline to a particular level, only to rebound and return a second time to that same level and to reverse once again upwards.
Source: http://www.investopedia.com/articles/forex/05/032805.asp
Interpretation
The appearance of double top and doubled bottom chart patterns within investment markets is a fairly common place occurrence. When these formations appear, they signify the market in question is testing previously recognized limits. These patterns can clearly show the price points where other market participants have demonstrated that they will resist and support any further movement beyond these levels. The appearance of these types of patterns is usually regarded as strong signals that penetration beyond the established limits cannot occur. As a result, these formations are viewed as indicators that a reversal in trend is likely to occur. The proper identification of these types of chart patterns represents excellent opportunities for the initiation of profitable trades.
One of the biggest problems concerning technical price chart patterns is that what historically appears to have been quite obvious is extremely difficult to identify during actual trading conditions. This can be particularly true as regards to double top and doubled bottom formations. As these formations arise with a high frequency in historical price charts, the successful identification and utilization of these patterns for trading purposes is very much an acquired skill that needs to be learned through practice over time. That being said, these patterns are relished by individual traders who recognize their utility for proper position taking in
successful trading activity. One can react to their formation by one of two methods that could be characterized as either reactive or proactive. The tactics used by the individual trader depends on that person's character and personality.
For those individuals who wish to be proactive in exploiting double tops and bottoms, the techniques used entails selling as the price approaches the identified top, and then re-purchasing and eliminating the position as the price declines to the bottom. Under this methodology, the investor is anticipating the reversal that is expected to occur. Traders who are more conservative in nature will stand by until the chart pattern has clearly been established, before entering into the appropriate position. This type of tactic reduces the risk of a double bottom or double top formation not actually completing the process of formation. It should be noted that though this is a conservative technique, at the same time, it significantly reduces the profit potential.
The most conservative fashion for trading double tops and bottoms is to wait for the actual formation and then to implement a position when a breakout occurs in order to benefit from the anticipated reversal. Generally, one would like to see declining volume when the second peak or second trough is approached and rising volume at the break up of or below the second top or bottom.
Double top and doubled bottom chart patterns are clear signals that the price movement has failed to break certain clearly established levels that are resistance barriers for double top formations and support barriers for double bottom formations. These types of chart patterns are generally considered reversal signals. A conservative investor will await their clear formation and a distinct breakout before entering a position. Profits, nonetheless, can be maximized when a trader becomes more sophisticated by actually trading the range established. Gains made during these range trading tactics are modest, but add to overall profitability. The risk, of course, is that the price moves out of the range, which is always inevitable. However, any loss that occurs during this price break would be modest, as the range trader would immediately reverse his or her position to take advantage of the trend reversal that has been identified by the
breakout.
Risk Management
In order to limit risks for these types of formations, depending upon whether a double top or double bottom is involved, stop loss orders are placed at the identified tops and bottoms. The rationale behind this risk management technique is that as soon as the formation has been broken, this should be viewed as pattern failure, and as such, the investment position should be liquidated. This, however, is not always the case. Most investment markets are now dominated by large institutional participants and hedge funds. These players, during these types of chart patterns, will often liquidate their positions early in order to try to take advantage of smaller individual investors. Consequently, what arises are many stop loss orders on trades that would have been profitable, if left in place.
Initiative
Double top and double bottom chart patterns are common and therefore, represent opportunities for the investor to take advantage of what more often than not becomes a reversal in price movement. The successful utilization of these types of formations is always dependent upon the skills of the individual who has properly recognized them. Due to the frequency of the
occurrence of these types of chart pattern formations, is not difficult for the investor who wishes to use them as signals for the implementation of trades to acquire the expertise necessary for the proper utilization. It is highly recommended, no matter what type of chart formation an
individual trader wishes to utilize as strategies concerning his investments, to take the time to historically test the techniques anticipated to be used. Practice makes perfect. Individuals will find what true double tops and double bottoms are by this type of exercise. Once the techniques have been mastered, successful trading results are almost inevitable.
Triple Tops and Bottoms
One of the outstanding attributes of the chart patterns formations known as triple tops and triple bottoms is their exceptionally low failure rate. Some studies have shown successful trading possibilities over 95 percent of the time, when these types of formations materialize. One can successfully trade these opportunities both on and long and short break outs of established support and resistance levels. The greatest success, however, occurs when a trader goes long after the formation of a triple bottom, and short when the triple top chart pattern has been broken. Some research has suggested averaged gains approaching 40 percent. Gains are more likely in the 20 percent range based on a frequency distribution analysis. These are truly outstanding results. Volume can be important, especially in those circumstances when volume on the center bottom or top is below that of the last formation of a top or bottom. In these situations, the average gains tend to be even greater. In those circumstances when the opposite is true, though successful results can be expected, they are of a more modest nature.
Source: http://www.investopedia.com/university/charts/charts9.asp Formation
For every chart formation pattern, there are unique characteristics that will distinguish it from other formations. For triple bottoms and triple tops to occur, there has to be a clear support or resistance level that has been approached and repelled three times. During the beginning of the pattern, from the first to the second top or bottom, there appears to be a broadening right angled ascending or descending directional movement with a horizontal bottom or top and a
consequential up sloping or down sloping trend line.
Prices always need to stop their movement at or about the same level. The tops and bottoms must be clearly distinct. The price variations at these levels must be minimal. The center top or
ottom is not significantly above or below the other two, as this would be an indication of a head entail differing
onsequences. The overall volume trend for triple tops and bottoms chart patterns is usually nd they are the weakest at the last relative high or low formation. This type of chart attern usually takes a significant amount of time to form on a historical price chart.
st volume
n
observation,
enerally, the trader would prefer to see a decreasing volume of activity for each subsequent e
for triple tops. Triple tops and bottoms that form when no significant price move as occurred do not tend to be very well separated. When this happens, one should be
b
and shoulders or reverse head and shoulders formation, which could c
downward, a p
Volume behavior is not critical during these types of formations. However, they do possess a confirmatory nature when it comes to position taking. Historically, for each of the subsequent tops and bottoms that are recorded in a price chart, volume tends to peak preceding the formation of each individual top or bottom, with the first initial top or bottom showing the highe
within the trio.
The rallies or falls in prices for each of the individual high points or low points in the formatio of a triple top or triple bottom chart pattern should be pronounced. The upper-level support and lower-level resistance levels that appear represent the area where consideration should be taken for the implementation of a position. Regardless of which type of formation is under
break out of this identified channel on the up side represents a long trading opportunity, while with the penetration on the down side, one should consider entering a short position.
G
high or low that is exhibited within the chart pattern. These formations tend to be more
successful when they occur after a significant move upwards or downwards. In other words, th investor should be more suspicious of a triple bottom that occurs after a significant or
intermediate uptrend, rather than one that occurs after prices have fallen substantially. The opposite is true
h
suspicious. This should be viewed by the trader as a price pattern that does not represent a true formation of a triple top or bottom. One should be always weary of this type of visual formation that has not occurred after a significant substantial movement in one direction or another. Trading Strategies
When trading triple tops and bottoms, a target price is derived by adding the differential between t,
o lace to a stop loss back at the penetration point. This tactic entails recognizing a modest loss
of retracements occur. He or she would then enter once again when
ops mize the profit potential of the trend reversal.
the highest high and the lowest low that is evident within the chart pattern to the breakout poin which would be the upper trend line for a triple top and the bottom trend line for a triple bottom. The entry point for a long position would be the point of penetration represented by the upper resistance line that has been identified, while the entry point for short position would be that point as shown on the lower support line.
Re-penetration of prices back into the trading range after a breakout has occurred is not uncommon, before the reversal of prices continues in the direction of the original breakout. Consequently, an investor has two possible tactics concerning stop losses. One would be t p
when these instances
penetration reappears. This may create a series of modest losses that are later recuperated. An alternative strategy would be to place the stop at the opposite trend line in the formation. This would minimize the number of losses; however, when a true formation failure occurs, the loss that occurs using this tactic would be substantial.
When an anticipated reversal in trend appears, the trader should institute a series of trailing st at identified support levels in order to maxi
Flags and Pennants
frequently happens that when an investment market is trending, the market will stagnate over a ertain period of time before deciding to continue or reverse the previous trend established. The hart patterns that form during these periods of consolidation often resemble what are referred to s flags and pennants in technical analysis terminology. The occurrence of these events
represents excellent opportunities to undertake an investment position. ormation
hen connecting the relative highs and lows during a precedent time period in a historical price lines run parallel, resembling a small angled rectangle, the chart attern that has been formed is referred to as a flag. If these two trend lines, on the other hand, converge to a point to resemble a triangle, this type of formation is called a pennant.
ennants are formed during periods of contracting prices and represent a consolidation of price
g trend It c c a F W
chart, if the subsequent trend p
P
activity. Pennants are distinguished from similar formations referred to as triangles, in that the pennant is not symmetrical, and does not possess a horizontal trend line. For an investor, being able to identify flags and pennants will allow him or her to be able to establish entry points for positions. This, in turn, can produce profitable results by following the existing underlyin price movements that have been clearly established.
Source: http://www.investopedia.com/ iversity/charts/charts6.asp
stment market, activity will ing in erlying trend. When this type of situation materializes, prices can be observed to be trading within a relatively narrow range. Upon the observance of such an event, the potential investor can connect the relative highs and lows in order to obtain trend lines for signaling purposes. When price trading activity remains within the identified two trend lines, the price stagnation of the market in question remains intact.
Trading Strategies
When the price starts to trade outside the identified consolidation range, and moves in the
direction of the previous established trend, this is a distinct signal for the investor to contemplate the possibility of entering a position. There are various techniques that are utilized by traders to
ke advantage of these chart pattern formations. The most obvious tactic is to wait for a price t to ensure that a false signal as not been established. Once the investor is confident that the breakout is in fact real, he or she
hen implementing or considering the entry into an investment position, price goals need to be ndertaking the position. The common practice with the utilization of flag nd pennant chart formations is to measure the distance from the highest high to the lowest low
ation un
Following a distinctive price movement that has occurred in an inve
ore often than not stall, and perhaps even retrace the movements slightly before resum m
the direction of the established und
ta
movement that is a certain amount above or below the breakout poin h
undertakes the appropriate position. A more conservative approach is to wait and see if a retracement to the original trend line occurs. If that trend line supports the price and then proceeds to move in that direction of the underlying trend, the probability of success of the position is greatly enhanced. Though the likelihood of a profitable trade increases, the investor also runs the risk a retracement does not occur, and, therefore, the position entry will be less than optimal towards the maximization of profits.
W
established prior to u a
observable in the chart pattern that has been identified. Upon entry, the exit price for liquid of the position would be the range that has been identified, added or subtracted from the entry price, depending upon whether a long or short investment was undertaken. Not all subsequent movements will achieve these range goals that have been set. As a result, the probability of successful trades can be increased by taking simply a certain percentage of the range as the profit goal.
Proper recognition of chart formations and the breakouts that arise from these patterns is a s that needs to be developed by any investor. This skill can only arise from experience and practice. Within the context of flags and pennants, this is especially important, if one does not want to be fooled into an entry because of a fa
kill
lse signal. Such occurrences will always result in nwanted losses. When using these types of techniques for investment purposes, no one should
d
when and if they occur. As it concerns pennants and flags, stops are normally placed a certain odest percentage above or below the original trend lines that were penetrated. The trend line
in an established trend. These patterns represent exceptional opportunities for profits with mited downside risk, as the stops are easily identifiable and when triggered represent modest u
blindly just start trading without first developing a comfort level and mastery of the techniques involved by trying to replicate trades on a blind basis using this historical data that is readily available. Only when the strategies and techniques have been proven in such a manner should an individual actually contemplate using real capital.
Regardless of the expertise developed, no successful trader enters a trade without being prepare for the worse to happen. As per Murphy's Law, "Whatever can go wrong, will go wrong!" Whenever a trade is implemented, stop loss orders should also be placed in order to limit losses, m
itself should not be the stop loss limit, as often during these formations these original trend lines tend to serve as support levels during retracements. Consequently, after resumption of the original established price trend, retracements can often be observed to the original breakout points. As a result, in order to avoid the creation of a loss that would have resulted in a gain, the stop loss point needs to be below or above the original entry signal to ensure that formation failure has occurred.
Flags and pennant chart formations allow an investor to take advantage of a temporary stagnation li
losses relative to the gains achieved during successful results. Flags and pennants are established tools for successful investment strategies.
Head and Shoulders
art pattern formations are generally classified on the basis of their significance to the derlying current trend that has been generated by the price movements that are graphically presented on a historical chart. Reversal patterns are those types of formations signaling the
d of the trend in the probable movement in the opposite direction. Head and shoulder chart tterns are one such reversal formation that is actively utilized by investors in order to dertake trades in an investment market.
e of the most popular chart patterns used by investors is called the head and shoulders top rmation. The reason for its popularity is that some studies have shown that up to 93 percent of e time, when a breakout occurs on the downward side, the likelihood of continued downward ovement is very high. Another reason for the popularity of this formation is the relative ease of cognition. It is easy to see on a historical price chart, since it simply consists of three
nsecutive high points, with the middle high point higher than the ones preceding and following Ch un re en pa un On fo th m re co it. Source: http://www.investopedia.com/terms/h/head-shoulders.asp Formation Characteristics
Typically, the highest volume can be seen during the formation of the head, or previously during the formation of the left shoulder. Following the formation of the head, there is always a
significant drop in volume. A trend line drawn along the two low points between the three peaks forms what is called the neck line. This trend line can neither slope upwards or downwards and the direction is considered inconsequential, though it has sometimes been correlated as a
predictor of the intensity of the subsequent price decline.
The head and shoulders top pattern often arrives with a variety of shapes. Sometimes they can have multiple shoulders on either side of the head. This formation typically appears at the end of a long movement of prices upwards. If the prior uptrend has been of a relatively modest
duration, the subsequent correction downward after the appearance of the head and shoulder nal start of the preceding chart pattern usually results in prices falling back down to the origi
ptrend. u
Trading Strategies
When using the head and shoulders chart pattern as a trading signal, most traders calculate a target price by measuring the distance from the highest price reached at the head to the
corresponding point on the neckline drawn below. As mentioned previously in this book, these target prices are just customary practices used by traders, and research has shown that the extent of movement downward upon a breakout of a head and shoulders formation will not alwa
reach this target. The smaller the percentage of profit desi
ys red relative to the target range creases the probability of a successful trade. Entrance to the trade occurs when the price
signal f or having a stop loss order a modest amount above the original neck piercing point of
gher of the two previous lows represented by the shoulders. It is not ncommon for the price to recuperate to the neckline, and then fail to penetrate, and proceed
th the
ead ink of
of a with the same potential results. There is a clearly
entifiable low-price with upside down shoulders to the left and to the right of the midpoint low. ies , a ated ersonality. d ld also in
breaks downwards below the neckline.
Since this type of chart pattern rarely fails, most traders do not insist upon a confirmation before undertaking a position. On rare occasions, subsequent to breaking under the neckline, prices will recuperate and move higher. Consequently, a trader should always protect himsel herself by
entry, or above the hi u
sharply lower. Some traders use this as a signal to increase their position. When considering such a strategy, the trader should always be certain that prices have fallen back undernea neckline a minimum amount.
When a chart formation on a historical price chart exhibits the opposite or mirror image of a h and shoulders top formation, it is referred to as an inverse head and shoulders. You can th it as someone standing on his head. However, it generally exhibits the same characteristics normal head and shoulders chart pattern
id
Once the neckline is broken, it signifies that significant resistance has been overcome and represents an excellent opportunity for upward movement. This type of chart formation signif that the previously identified downtrend has reversed itself, and that prices should move appreciably higher in the opposite direction. As with the normal head and shoulders formation conservative investor may wish to witness a retracement back to the neckline and demonstr support before undertaking an investment position. A more aggressive trader will simply buy when the neckline is broken because of the high probability of success that has been
demonstrated historically. The type of strategy employed by any particular individual will be a function of his or her trading p
For any reversal pattern formation, such as head and shoulder chart patterns, when the neckline is broken, it immediately becomes a resistance level of particular importance, especially for those instances when formation failure occurs. These data pattern formations will often show retracements back to the original neckline that signaled the pattern reversal. During the
overwhelming majority of instances when this occurs, the price will be successfully supported at that level and then subsequently resume the reversal of trend that has been demonstrated an signaled. This does not happen each and every time, unfortunately. Consequently, upon implementation of any trading position based on the penetration of the neckline, one shou have stop loss order in place, a certain percentage above or below the penetration point,
depending upon whether a normal or inverse head and shoulders formation is under consideration.
The head and shoulders chart pattern is considered to be one of the most reliable and classic technical analysis tools available for a trader in the investment markets. However, any tool is
t, a on only as effective as the person who has learned how to use it. Because of this fact, it cannot be emphasized enough that prior to taking and risking any real capital in no matter which marke trader should hone his skills to perfection. As a result, prior to using any of the chart patterns explained in this book, it is very important for the individual to practice their recognition historical data that is readily available.
Island Reversals
other relatively common chart pattern used by investors for trading purposes is referred to as and reversals. The appearance of a gap when it occurs alone provides evidence that there has en an important development concerning the fundamentals or psychology of the traders that s caused this movement to occur in market price action. This sudden movement in price by an vestment can only signify a significant change in demand. When these gaps appear within the rmation of an island on a price chart, they can represent an opportunity for the investor for a w risk, high probability trading opportunity.
and reversals typically appear after an extended trend upwards or downwards and always gin with a price gap trading day in that direction, usually the result of some sort of unexpected ws. This unexpected breakout in the direction of the trend occurs with an exceptionally high lume relative to average previous trading activity. The price movement, however, cannot
after several days, prices fail to move significantly in the direction of the end. Market participation fails to sustain the movement. What usually happens next is the
and throwbacks are quite common, conservative investors will delay taking a position until this
. The gaps materialize usually at the same price level, but are not necessarily the same size. It is important in the
pattern e to An isl be ha in fo lo Isl be ne vo
maintain itself, and tr
appearance of some sort of fundamental news event that contradicts the original information producing the first gap, and a new gap appears in the opposite direction
Studies have shown success rates of as high as 87% for tops, and 83% for bottoms. The
problems associated with this type of formation are that the gains that can be acquired are usually modest relative to other types of chart patterns. As a result, they should be considered for
investment positions that would be held for only a relatively short period of time. As pullbacks action has been completed and prices reconfirm their breakout direction.
Formation Characteristics
Island reversals are generally easily identified. Both of these types of reversals, regardless of whether they are bottoms are tops, begin with a gap movement in the appropriate direction followed by another gap in the opposite direction. The first gap is usually referred to as an exhaustion gap, followed by a second one referred to as a breakaway gap
identification of an island reversal that the gaps occur at the relative same price level. The that is evident is what can visually be identified as a type of island. Trading volume should be accelerating at the time of the initial breakout gap, as well as the subsequent reversal relativ the volume that preceded each of them.
Source: http://www.shareselect.com.au/knowledge-bank/Technical-Analysis/Gaps-Island-Reversal/
Trading Strategies
price for an island reversal chart formation is usually arrived at by taking the range presented by the highest high and the lowest low identified in the pattern, and then adding or
ence appropriately. As a result, for an island bottom formation, this ifferential would be added to the highest high, whereas for an island top chart pattern, it would
d
verse direction and recover before resuming the trend demonstrated by the breakout. onsequently, when trading this type of formation, it is often advisable to wait for the pullback
has
best way to profit from these sorts of chart patterns is to wait for enetration and then subsequent support to appear at the previous trend line identified during a
ough The target
re
subtracting this differ d
be subtracted from the lowest low. The price is arrived at represent potential targets. These ranges are rarely achieved in subsequent movement, and simply serve as a point of reference an guidance.
Price movements subsequent to a breakout, traditionally show reluctance in continuing the directional movement demonstrated by the breakout. After a breakout occurs, prices often are likely to re
C
to the original breakout level before assuming an investment position. In other words, there to be a clear piercing of the trend line and a return to that approximate level before entry into a position is contemplated.
Though these formations have a demonstrated low failure rate, the subsequent movement upon their creation is typically been modest. Profit expectations on the part of the trader should, therefore, be similar. The
p
reversal, followed by the resumption of the original trend demonstrated upon breakout, before taking a position. After a modest gain has been accomplished, liquidate the investment. Th these types of chart patterns are actively used by traders because of the frequency of their appearance, unlike other chart formations, these patterns have historically been shown not to be signals of significant large trend reversal movements and should be utilized accordingly.
Investors should note that the formation of island reversal chart patterns are usually news driven and occur because of conflicting informational events that arise within a relatively short time frame. As a result, it would be beneficial for the trader to be aware these news developments in
ect
in the direction of the trend. Subsequent trading over the next few days will usually occur in a relatively narrow range and then be followed by a gap
nd. r order to produce profitable results in trading activity. Formation of island reversals without any news rationale behind them that can be clearly identified should be considered somewhat susp on the part of the trader contemplating an entry because of the identification of this type of pattern on a historical price chart.
When prices have trended upwards or downwards over a significant period of time, it is not uncommon to view a gap price day
trading day in the opposite direction. The formation is easily identified and represents an isla Such situations are not uncommon and have been shown to produce modest profitable results when treated properly. It is a formation that can be used by any investor to increase his or he wealth.
Ascending Triangles
ferred to as ascending triangles are probably one of the most popular atterns among investors who use technical analysis tools to make investment decisions
ed return
ng triangle concerns the fact that for most vestments, during certain times, there will be an adequate supply of the investment available
s considered relevant when the price movements in an historical price chart roduces a horizontal trend line when the relative minor highs are connected, as well as an up
t to en
difficult, and perhaps too simple, s it is probably one of the most misidentified chart formations in technical analysis. If at any
e
gle, the horizontal trend line represents resistance and should have
emonstrated several attempts of a lack of penetration where the price falls to this support trend s
the
initially strong, but then reduces itself until the ccurrence of a breakout. Volume is typically low precedent in this breakout, as an indication
e The chart formations re
p
concerning their capital. The reason for this popularity is the strong average return document in historical studies when an upside breakout occurs. Some research indicates an average
of 44%. When this data is viewed from a frequency distribution perspective, however, the return is more like 20%, which is actually quite respectable.
One explanation of the price movements of an ascendi in
within a certain range. The point at which that supply becomes depleted causes a breakout of the price from the formation, forcing a sharp move higher. If demand continues to materialize, the prices remain strong. Otherwise, the investment falls back onto itself and either regroups for another attempt at rising, or continues downward.
Formation The pattern i p
sloping trend line when the relative minor lows are connected. These trend lines intersec reveal the characteristic triangular pattern. Volume generally diminishes as prices range betwe the support bottom trend line and the resistance top trend line.
Ascertaining an ascending triangle on a daily price chart is not a
time a trader questions the validity of a particular chart pattern, the likelihood is that there are other investors who share the same feeling. The use of chart patterns as successful tools, by a trader, requires recognition as such by the market. As a result, if you do not properly recogniz the chart pattern, the probability that the event will produce the results that you anticipate is greatly diminished.
In an ascending trian d
line underneath and is repelled. The ascending support trend line on the bottom is alway sloping upwards, from which derives the name of this formation as an ascending triangle. The top horizontal trend line must have demonstrated resistance at least twice and should have upward sloping support trend line underneath.
During the formation of this triangle, volume is o
that the formation is amassing strength for the eventual penetration. When this upside breakout occurs, volume is typically is much heavier, but this is not considered a prerequisite in this particular pattern formation. It is not uncommon for a breakout to occur and then subsequently be supported by the bottom trend line before the final breakout and a significant upward pric movement occurs and results. Once the final penetration occurs, prices tend to rapidly rise and
