Technical Analysis Explained Read online

  Broadening Formations

  Broadening formations occur when a series of three or more price fluctuations widen out in size so that peaks and troughs can be connected with two diverging trendlines. The easiest types of broadening formations to detect are those with a “flattened” bottom or top, as shown in examples a and b in Figure 8.31.

  FIGURE 8.31 Right-Angled Broadening Formations

  The patterns in Figure 8.31 are sometimes referred to as a right-angled broadening formation. Since the whole concept of widening price swings suggests highly emotional activity, volume patterns are difficult to characterize, though at market tops, volume is usually heavy during the rally phases. The patterns at both bottoms and tops are similar to the H&S variety, except that the “head” in the broadening formation is always the last to be formed. A bear signal comes with a decisive downside breakout. Volume can be heavy or light, but additional negative emphasis arises if activity expands at this point.

  Since a broadening formation with a flattened top is an accumulation pattern, volume expansion on the breakout is an important requirement, as shown in example b in Figure 8.31. Examples of broadening formations are shown in Chart 8.13 for WW Grainger and Chart 8.14 for the copper price.

  CHART 8-13 WW Grainger: A Right-Angled Broadening Formation. This chart shows that it is not always possible to draw the outer boundaries of the pattern so that they connect all the peaks and troughs exactly. The most important thing is to make sure that the bottoms diverge and that the tops form at roughly the same level. The concept is one of growing instability on the downside that is “unexpectedly” reversed to the upside.

  CHART 8.14 Copper 2000–2002. It Features Two Broadening Formations

  Notice how the bearish one exceeded its price objective by three times. That third multiple proved to be the end of the decline, following which a bullish broadening formation was formed. The power of these patterns can also be appreciated from Chart 8.14, which shows the formation of another right-angled pattern coming off the 2009 bottom. These two types of broadening formations can also develop as consolidation patterns. A bullish one is featured in Figure 8.32.

  FIGURE 8.32 Consolidation Right-Angled Broadening Formation

  Broadening formations occasionally fail to work. Possibilities are shown in Figure 8.33. Unfortunately, there does not appear to be a reliable point beyond which it is safe to say that the pattern has failed to operate. The best defense in such cases is to extend the diverging trendlines, i.e., the dashed lines in Figure 8.33, and await a decisive penetration by the price as confirmation.

  FIGURE 8.33 Broadening Formation Failures

  When completed, right-angled broadening formations of both the reversal and the continuation type result in a particularly dynamic move. It is almost as if they are aborted H&S formations in which the move is so powerful that there is not time to complete the right shoulder. An example of a bullish right-angled broadening formation, where the price objective was achieved multiple times, is shown in Chart 8.15 for Patni Computers.

  CHART 8.15 Patni Computers 2007–2008. Broadening Formation with Multiple Price Objectives

  A variation on the right angled broadening formation is the broadening wedge. These patterns are similar in that they consist of two diverging trendlines, but instead of one of them being constructed at an angle of 90 degrees, it slopes up (or down in the case of a bullish pattern) but at a smaller angle of ascent (descent), as shown in Figures 8.34 and 8.35.

  FIGURE 8.34 Bearish Broadening Wedge

  FIGURE 8.35 Bullish Broadening Wedge

  The measuring implications and other characteristics are identical to those of the right-angled variety.

  The final type of broadening formation, known as an orthodox broadening top, is shown in Figure 8.36.

  FIGURE 8.36 Orthodox Broadening Formation

  This pattern comprises three rallies, with each succeeding peak higher than its predecessor, and each peak separated by two bottoms, with the second bottom lower than the first. Orthodox broadening formations are associated with market peaks rather than market troughs.

  These patterns are extremely difficult to detect until some time after the final top has been formed, since there is no clearly definable level of support where the violation of which could serve as a benchmark. The violent and emotional nature of both price and volume swings further compounds the confusion and increases the complexity of defining these situations. Obviously, a breakout is difficult to pinpoint under such conditions, but if the formation is reasonably symmetrical, a decisive move below the descending trendline joining the two bottoms, or even a decisive move below the second bottom, usually serves as a timely warning that an even greater decline is in store.

  Measuring implications are similarly difficult to determine, but normally, the volatile character of a broadening top formation implies the completion of a substantial amount of distribution. Consequently, price declines of considerable proportion usually follow the successful completion of such patterns. The problem is that they are quite rare and do not show up on the charts very often.

  Triangles

  Triangles, the most common of all the price patterns discussed in this chapter, are unfortunately the least reliable. They may be consolidation or reversal formations, and fall into two categories: symmetrical and right-angled.

  Symmetrical Triangles

  A symmetrical triangle is composed of a series of two or more rallies and reactions in which each succeeding peak is lower than its predecessor, and the bottom from each succeeding reaction is higher than its predecessor (see Figure 8.37).

  FIGURE 8.37 Symmetrical Triangles

  A triangle is, therefore, the opposite of a broadening formation, since the trendlines joining peaks and troughs converge, unlike the (orthodox) broadening formation, in which they diverge.

  These patterns are also known as coils, because the fluctuation in price and volume diminishes as the pattern is completed. Finally, both price and (usually) volume react sharply, as if a coil spring had been wound tighter and tighter and then snapped free as prices broke out of the triangle. Generally speaking, triangles seem to work best when the breakout occurs somewhere between one-half and three-fourths of the distance between the widest peak and rally and the apex (as in Figure 8.38).

  FIGURE 8.38 Classic Symmetrical Breakout

  The volume rules used for other patterns are also appropriate for triangles. Another factor that affects reliability emanates from one of the principles of determining trendline significance. While a triangle can theoretically be constructed by joining four turning points, two for each line, it follows that those lines will gain greater significance if touched or approached on more numerous occasions. Consequently, when they are eventually violated, their more formidable role as a dynamic support/resistance zone will likely result in a more trustworthy signal.

  Major Technical Principle The more times the lines forming a triangle have been touched or approached, the greater the probability that their eventual violation will be valid.

  Right-Angled Triangles

  Right-angled triangles are really a special form of the symmetrical type, in that one of the two boundaries is formed at an angle of 90 degrees, i.e., horizontal to the vertical axis. An example is illustrated in Figure 8.39.

  FIGURE 8.39 Right-Angled Triangles

  The symmetrical triangle does not give an indication of the direction in which it is ultimately likely to break, but the right-angled triangle does, with its implied level of support or resistance and contracting price fluctuations. One difficulty in interpreting these formations is that many rectangles begin as right-angled triangles. Consequently, a great deal of caution should be used when evaluating these elusive patterns. An example is shown in Figure 8.40, where a potential downward-sloping right-angled triangle in example a, develops into a rectangle in example b.

  FIGURE 8.40 Triangle Failures

  Traditionally, measuring objectives for triangles are obtained by d
rawing a line parallel to the base of the triangle through the peak of the first rally. This line (BB in Figure 8.41) represents the objective that prices may be expected to reach or exceed.

  FIGURE 8.41 Triangle Measuring Implications

  The reverse procedure at market tops is shown in Figure 8.41, examples c and d. The same technique is used to project prices when triangles are of the consolidation variety. However, in my own experience, I have not found this method to be particularly useful. I prefer, instead, to treat the triangle as with any other pattern by calculating its maximum depth and then projecting this distance at the breakout. An example of this alternative method is shown in Figure 8.42.

  FIGURE 8.42 Alternative Triangle Measuring Implications

  An example of a right-angled triangle followed by a bullish broadening formation is shown in Chart 8.16 featuring the DJIA.

  CHART 8.16 DJIA 1938. This excellent example of a right-angled triangle occurred at the bottom of the 1937–1938 bear market. Note the substantial volume that accompanied the upside breakout. Following the breakout, the average traced out a right-angled broadening formation with a flat top. Usually, breakouts from these consolidation patterns are followed by a dramatic rise. In this case, however, the 158 level in November was destined to become the high for the 1938–1939 bull market.

  Cup with a Handle

  This pattern has been made famous by William O’Neil and is described in his How to Make Money in Stocks (McGraw-Hill, 1995). The pattern develops as a bullish one, usually in a continuation format. Figure 8.43 shows that it takes the form of a big U (the cup), followed by a rally and a small rounding platform (the handle). The cup is typically preceded by a very strong rally, so the left side reflects aggressive profit-taking.

  FIGURE 8.43 Cup-and-Handle Formation

  The left part of the cup usually marks the culmination of a strong rally and is often associated with heavy volume. The bottom of the cup can take the form of a rounding bottom, as in Figure 8.43, or some ranging action, as in Figure 8.44.

  FIGURE 8.44 Alternative Cup-and-Handle Formation

  The next step in the development of this pattern is a rally on expanding volume, followed by a period of profit taking in which both volume and price go quiet. Finally, the handle is completed and prices explode to the upside.

  If it is going to fail, the signal to look for is a break below the lower part of the handle. If the price eventually breaks above the upper level of the handle, the situation will again become bullish. Any breakouts that develop with shrinking volume, though, should be regarded with suspicion.

  Chart 8.17 shows a cup with a handle formation for ADC Telecom. The breakout above the handle is not accompanied by much of an expansion in volume, but the price certainly doesn’t suffer.

  CHART 8.17 ADC Telecom 1990–1991 Cup-and-Handle Formation

  By its very nature, the cup with a handle is a consolidation formation. Since the breakout follows a shakeout move (the left part of the cup), it is often followed by a very strong rally.

  Summary

  1. Prices in financial markets move in trends. A reversal is characterized by a temporary period in which the enthusiasm of buyers and sellers is roughly in balance. This transitional process can usually be identified by clearly definable price patterns, which, when completed, offer good and reliable indications that a reversal in trend has taken place.

  2. Until a pattern has been formed and completed, the assumption should be that the prevailing trend is still operative, i.e., that the pattern is one of consolidation or continuation. This principle is more important when the trend has been in existence for only a relatively short period, because the more mature it is, the greater the probability of an important reversal.

  3. Price patterns can be formed over any time period. The longer the time required to form a pattern and the greater the price fluctuations within it, the more substantial the ensuing price movement is likely to be.

  4. Measuring formulas can be derived for most types of patterns, but these are generally minimum objectives. Prices usually extend much further.

  5. Price objectives represent the minimum ultimate target and are not normally achieved in one move. Usually, a series of rallies and reactions in an upside breakout is required, or reactions or retracements in a downside breakout, before the objective is reached.

  9 SMALLER PRICE PATTERNS AND GAPS

  Most of the price patterns described in Chapter 8 can be observed in both reversal and continuation formations. The majority of the formations discussed in this chapter materialize during the course of a price trend and are, therefore, of the continuation variety. Since many of them are reflections of controlled profit-taking during an advance and controlled digestion of losses during a decline, these patterns, for the most part, take a much smaller time to form than those described in the previous chapter. They most commonly appear in the daily charts.

  Flags

  A flag, as the name implies, looks like a flag on the chart. It represents a quiet pause accompanied by a trend of declining volume, which interrupts a sharp, almost vertical rise or decline. As the flag is completed, prices break out in the same direction that they were moving in prior to its formation. Flags for both an up and a down market are shown in Figure 9.1.

  FIGURE 9.1 Flags

  Essentially, they take the form of a parallelogram in which the rally peaks and reaction lows can be connected by two parallel lines. The lines move in a countercyclical direction. In the case of a rising market, the flag is usually formed with a slight downtrend, but in a falling market, it has a slight upward bias. Flags may also be horizontal.

  In a rising market, this type of pattern usually separates two halves of an almost-vertical rise. Volume is normally extremely heavy just before the point at which the flag formation begins. As it develops, volume gradually dries to almost nothing, only to explode as the price works its way out of the completed formation. Flags can form in a period as short as 5 days or as long as 3 to 5 weeks. Essentially, they represent a period of controlled profit-taking in a rising market.

  The development of the flag in a downtrend is also accompanied by declining volume. This type of flag represents a formation with an upward bias in price, so the volume implication is bearish in nature, i.e., rising price with declining volume. When the price breaks down from the flag, the sharp slide continues. Volume tends to pick up as the price slips below the flag’s lower boundary, but it need not be explosive. Only upside breakouts in bull markets require this characteristic.

  It is important to make sure that the price and volume characteristics agree. For example, the price may consolidate following a sharp rise, in what appears to be a flag formation, but volume may fail to contract appreciably. In such cases, great care should be taken before coming to a bullish conclusion, since the price may well react on the downside. A flag that takes more than 4 weeks to develop should also be treated with caution because these formations are, by definition, temporary interruptions of a sharp uptrend. A period in excess of 4 weeks represents an unduly long time for profit-taking and, therefore, holds a lower probability of being a true flag.

  Flag formations are usually reliable patterns from a forecasting point of view, for not only is the direction of ultimate breakout indicated, but the ensuing move is also usually well worthwhile from a trading point of view. Flags seem to form at the halfway point of a move. Once the breakout has taken place, a useful method for setting a price objective is to estimate the size of the price move in the period immediately before the flag formation began and then to project this move in the direction of the breakout. In technical jargon, flags, in this sense, are said to fly at half-mast, i.e., half way up the move. Since flags take a relatively short period to develop, they do not show up on weekly or monthly charts.

  Chart 9.1, featuring Adaptec, shows a flag together with the measuring implications, as shown with the two dashed arrows.

  CHART 9.1 Adaptec Flag

  Pennants

/>   A pennant develops under exactly the same circumstances as a flag, and has similar characteristics. The difference is that this type of consolidation formation is constructed from two converging trendlines, as shown in Figure 9.2.

  FIGURE 9.2 Pennants

  In a sense, the flag corresponds to a rectangle, and the pennant to a triangle, because a pennant is, in effect, a very small triangle. The difference between them is that a triangle consists of a trading range bound by two converging trendlines that point in different directions. In the case of a pennant, they both move in the same direction. If anything, volume tends to contract even more during the formation of a pennant than during that of a flag. In every other way, however, pennants are identical to flags in terms of measuring implication, time taken to develop, volume characteristics, etc.

  Chart 9.2 features a pennant for Adobe in an up market. Note how the volume shrinks during the formation of the pattern. It then expands on the breakout.

  CHART 9.2 Adobe Pennant

  Wedges

  A wedge is very similar to a triangle, in that two converging lines can be constructed from a series of peaks and troughs, as shown in Figure 9.3, but whereas a triangle consists of one rising and one falling line, or one horizontal line, the converging lines in a wedge both move in the same direction.