Learning any new skill, such as driving a car, is awkward. Basic task recognition skills, such as putting the car in drive and even adjusting the side or rear windows, is a project. Once the car is rolling, simple procedures, such as changing lanes and parallel parking, take time to learn. Most of us perform these skills without a second thought now, but that wasn’t always the case.
Trading is the same way, particularly when it comes to the skill of pattern-based analysis. Recognizing price patterns is a thought process that you must do instantaneously to be effective. In this article, we will examine some advanced chart patterns that are relatively simple to recognize in the real world and lend themselves well to a novice.
There are a few basic concepts to understand in chart pattern analysis. Market trends have only three directions to go: up, down or sideways. As traders, we are attempting to understand where we are in the trend. We must know whether we are in a new trend or one that is well established and possibly getting long in the tooth. If we are late in the trend, we must be able to recognize the signs of a reversal. If not, we need to recognize signs of a continuation.
To do that, we must come to understand points on the chart where reversals or continuations can materialize: support and resistance zones. Support and resistance zones are magnets that attract price action. These zones act as forks in the road; either they will hold or they won’t. If they always held, all financial markets would be in a perpetual trading range, and we know that isn’t the case. In our series of examples we will look at two types of advanced chart patterns: reversals and continuations.
WHEN ANALYSIS CONVERGES
Price action is attracted to support and resistance zones that can materialize at important moving averages, Fibonacci retracements or prior support/resistance areas. Many times, a moving average will line up with a Fibonacci line, and often, this is seen when the 50-period moving average lines up with the 38% retracement and the 200-day with the 61% retracement.
Depending on the situation, these lines may be retested. When they are, we see virtual or absolute double tops or bottoms. These double pivots can either be absolute highs/lows or secondary pivots.
The first example might be the most famous one of the decade (see “Time on your side”). After the initial drop when the Nasdaq bubble popped, there was a technical bounce that failed 88 days off the top. Markets move fast, and traders must be able to recognize a failure quickly.
Price and volume relationships are important, but there is another equally important element to becoming a master at chart pattern recognition: time. The Futures articles “Trading Stocks with Fibonacci and Lucas” (May 2007) and “Finding Patterns With The Lucas Time Series,” (September 2006) further explain how the time dimension of technical analysis can give the trader a real edge in recognizing patterns.
After the initial secondary failure, price action often retests this line of resistance again. Many times, it’s this second test of a high, or a double top that confirms ultimate resistance and reversal. In this case, confirmation comes another 35 days down the road at a Lucas 123 days off the top. Notice how these pivots confirm with Evening Star candle formations and how price action acts as the magnet. Many times these double pivots will lead to at least short-term trade setups but it depends on the time scale. The Nasdaq chart is on the daily scale. Once the “where” is established, begin to think about the “when.” The answer to this question is the time factor and is confirmed by candlestick formations.
“Doubling down” is a sequence in the Dow Jones Industrial Average from the October 2005 low to the May 2006 high and then down to the end of that correction. At the May high, the duration of the rally is 144 days, and the reversal is confirmed by an Evening Star or bearish engulfing candle pattern. Price action continues downward until it hits the 61% retracement level of the rally leg up in June 2006.
The S&P 500 index also fell in June, but technology (or even the Nasdaq) didn’t bottom until July. As far as the Dow was concerned, it elected to retest that support zone. By July, sentiment was incredibly bearish, and the entire market bottomed in that period. Technically, the bottom was formed when support was retested to create a virtual double bottom. For good measure, the whole correction was complete at the Lucas 47 + 1 time duration.
MISSING THE TURN
When you understand how these patterns work, you are well on your way to catching reversals in all markets. However, what happens if you’re late with your forecast? You don’t necessarily have to wait weeks or months for the next reversal. In fact, there may not even be a reversal to miss.
Price charts don’t necessarily show sentiment, but the market became incredibly euphoric in May 2006 only to make a complete 180-degree turn weeks later. This is an extreme example, but trends oscillate from overbought to oversold all the time. Most swings in emotion, on average, are smaller than 2006’s, and markets work off swings with smaller corrections known as continuation patterns.
Continuation patterns work off emotions without major reversals and keep the larger trend intact. Two of the more common ones are flag patterns and triangles.
Recent examples of both patterns materialized at the same time in the precious metals market (see “Break in trend”). The sector made an important low in August 2007. After a rally of 60 days, the sector became overbought, if not euphoric. When conditions don’t exist to complete an entire trend, the implication is that buyers are tired. The only participants selling are profit takers, not people trying to unload huge positions and a continuation pattern is spawned.
This is exactly what materialized in gold last November. Converging trendlines identify a triangle formation. A triangle must have the look of a triangle, according to Elliott Wave International (EWI). There is a difference between a triangle and a pure sideways consolidation. Also, the EWI reports, many triangles will be the next-to-last pattern before a top. Thrust measurements, which measure a triangle from the beginning to a perpendicular point in space below the point of origin when the lower trendline is extended backward to meet it, also are useful. That measurement can be added to the end of the triangle to target the end of the trend.
In the case of the gold chart, the concept is the same, yet the calculation is slightly different. When we measure the thrust, we multiply it by 2.618 and add it to the breakout. This provides a close approximation to the March high. It doesn’t always work out, but it demonstrates how the triangle can be the next-to-last pattern of a sequence before a more important correction.
As far as the time element goes, the triangle began within the 61-day window and completed in the 89-day window. The pattern did its job because by the time the trend continued, the overbought condition was worked off as evidenced by the pullback in the moving average convergence-divergence oscillator.
During the same period, the silver chart was tracing out a flag correction that worked off the same overbought condition in a continuing larger degree trend. In this case, the time calculations for the start and end are the same because these markets move together. These patterns exhibit good time precision, which is a tool in recognizing the potential of when the pattern can complete. The important aspect of this particular chart is the retest of the September to October consolidation period. Once buyers are convinced that sellers won’t take the action below support, they come back in to take the market higher.
Not all patterns are created equal. Some are easier to recognize because they are better organized. Some patterns that initially have the look of a developing triangle because of the converging channel lines have a tendency to blow out before completion. Some double pivots don’t exhibit well-defined candlestick reversal patterns.
The patterns that exhibit strong characteristics are usually reliable and lead to strong moves. From the bear market bottom in 2002 to the October high in 2007, the S&P 500 featured an entire bull market that spanned one complete 262-week cycle (see “Strong performer”). The top is characterized by a well-defined blended Evening Star reversal or bearish engulfing formation. As of July 2008, the new trend that was spawned by this price and time reversal is still in force. The Dow exhibited a similar pattern and finally broke through the 200-week moving average. This pattern is ideal in terms of a price and time cluster that is simple to recognize.
Pattern recognition is one of the most important tools in a trader’s arsenal. In the fast-paced environment of financial markets, it is vital to be able to recognize situations as opportunities and take advantage of them.
It’s not always easy, however. The biggest stumbling block to trading success may well be giving in to the emotion of the crowd, and many chart patterns require the individual to have a contrarian view. The implication is that when these patterns do materialize at tops, the crowd will be very euphoric. At market bottoms, sentiment will be fearful. These are psychologically uncomfortable places to place a trade.
However, just like driving a car, at first it may be intimidating, but you do get used to it. It is important to practice and observe many charts. Not only must the trader train his mind to recognize a good pattern, he must also train his emotions to tune out the noise of the crowd.
Jeff Greenblatt is the director of Lucas Wave International. He is the author of “Breakthrough Strategies for Predicting Any Market,“ a Marketplace book. He can be reached via www.lucaswaveinternational.com