Technical Analysis Explained Page 14

  Summary

  1. Flags, pennants, and wedges are short-term price patterns that usually develop halfway along a sharp price movement. Their development is normally complete within 3 weeks, on a daily chart and they represent periods of quiet price movement and contracting volume. They are almost always continuation patterns.

  2. Saucer formations and rounding tops are usually reversal patterns and are typically followed by substantial price movements. In both formations, volume contracts toward the center and is at its highest at either extremity.

  3. A gap is essentially a vacuum or hole in a bar chart. Ex-dividend and area gaps have little significance. Breakaway gaps develop at the beginning of a move, runaway gaps in the middle of a move, and exhaustion gaps at the end.

  4. The upper and lower areas of gaps represent potentially significant support and resistance areas.

  5. Island reversals are small price patterns or congestion areas isolated from the main price trend by two gaps. They often signal the termination of an intermediate move.

  10 ONE- AND TWO-BAR PRICE PATTERNS

  The price patterns we have considered so far take some time to complete, usually at least 20 bars. They all reflect changes in the relationship between buyers and sellers, which tells us that there has been a reversal in psychology.

  Major Technical Principle One- and two-bar patterns reflect changes in psychology that have a very short-term influence on prices.

  Historically, the patterns described in this chapter were called 1- and 2-day patterns or 1- and 2-week patterns. With the advent of intraday charts, the title “inside days,” “outside days,” etc., is no longer a generic term. Therefore, I have chosen to use the term “bar” to refer to these patterns, since that term applies to all charts from 1-minute bars up to monthly ones. (For a more in-depth discussion on these fascinating patterns, please see Martin Pring on Price Patterns [McGraw-Hill, 2005].)

  We have already established that a key factor influencing the significance of a pattern is its size. Since these one- and two-bar patterns do not take very long to form, they are, by definition, only of short-term significance. For example, a one-day pattern would only be expected under normal circumstances to affect the price over a 5- to 15-day period. A two-bar pattern created from 10-minute bars would influence the trend over the course of the next 50 minutes to an hour or so. Even so, the more I study these patterns, the more impressed I become with their ability to reliably signal short-term trend reversals.

  Major Technical Principle One- and two-bar patterns should be interpreted as shades of gray rather than as black or white because some patterns offer stronger signs of exhaustion than others.

  Therefore, not all are created equal. What we are doing is hunting for clues as to the degree of exhaustion being signaled by a particular reversal phenomenon. I could say the word “help,” for example, but if I shout it from the rooftop, you will get the message far more clearly that I need help. The same principle operates in the marketplace. For example, if the outside bar encompasses the trading range of three or four bars, it is likely, other things being equal, to be more significant than if it barely encompasses one, and so forth.

  There are some ground rules to bear in mind when interpreting these formations:

  1. They generally reflect an exhaustion point. In the case of an uptrend, such patterns develop when buyers have temporarily pushed prices up too far and need a rest. In the case of downtrends, there is little, if any, supply because sellers have completed their liquidation. Such formations are almost always associated with a reversal in the prevailing trend.

  2. In order for these phenomena to be effective, they must have something to reverse. This means that tops should be preceded by a meaningful rally and bottoms by a sharp sell-off.

  3. It is important to interpret these patterns not so much from a black and white perspective, but as shades of gray, because not all of them are created equal. Some show all of the characteristics I will be describing later in a very strong way. Others will reflect just a few characteristics in a mild way. What we might call a five-star pattern, with all the characteristics, is more likely to result in a strong reversal than, say, a two-star pattern that has mild characteristics. It is, therefore, necessary to apply a certain degree of common sense to their interpretation rather than jumping to an immediate conclusion that the presence of one of these patterns guarantees a quick, profitable price reversal.

  4. One- and two-bar formations may sometimes experience retracement moves in a similar way to classic price patterns. Since the extremities of most of these formations represent emotional (support/resistance) areas on the chart, retracements offer lower-risk entry points.

  Outside Bars

  Outside bars are those in which the trading range totally encompasses that of the previous bar. They develop after both down and up trends, and represent a strong signal of exhaustion. An example of a top reversal is shown in Figure 10.1, and a bottom in Figure 10.2. Note that example b shows what the bars would look like if they were displayed as rectangles, a smaller one followed by a longer one. Several subsequent figures reflect the same idea.

  FIGURE 10.1 Bearish Outside Bars

  FIGURE 10.2 Bullish Outside Bars

  There are several guidelines for deciding on the potential significance of an outside bar. They are as follows:

  1. The wider the outside bar relative to the preceding ones, the stronger the signal.

  2. The sharper the rally (reaction) preceding the outside bar, the more significant the bar.

  3. The more bars encompassed, the better the signal.

  4. The greater the volume accompanying the outside bar relative to previous bars, the stronger the signal.

  5. The closer the price closes to the extreme point of the bar away from the direction of the previous trend, the better. For example, if the previous trend was down and the price closes very near to the high of the outside bar, this is more favorable than if it closes near the low and vice versa.

  Some comparative examples of strong and weak outside bars are featured in Figure 10.3.

  FIGURE 10.3 Outside Bars Showing Different Characteristics

  When considering outside bars, or any of the other one- and two-bar price patterns, it is important to ask yourself the question “What is the price action of this bar telling me about the underlying psychology?” Wide bars, sharp preceding rallies or reactions, and high volume all suggest a change in the previous trend of sentiment.

  Chart 10.1 features the summer 2012 price action for the Dow Jones Utility ETF. In this case, the signal was a strong one because the bar was extremely wide, encompassed the trading range of three previous sessions, and closed near its low.

  CHART 10.1 Dow Jones Utility ETF Outside Bar

  Finally, the price rallied above the resistance trendline during the course of the day and closed well below it, thereby offering a classic signal of exhaustion. Also note that investors had a chance to revisit their emotions during the 2-day retracement move that took place in early August.

  Chart 10.2 shows a weekly outside bar for the cocoa price. This time, it’s the third in a series of three outside bars. The effect is that they reinforce each other and produce a very strong signal.

  CHART 10.2 Cocoa 1999–2000 Outside Bars

  In addition, notice that the final outside bar also closes above the support/resistance trendline joining several lows. This indicated that the downside break was a whipsaw, which added even more icing to the bullish cake.

  Finally, Chart 10.3 features a daily chart of the NASDAQ 100. The outside bar on the left has a lot of the ingredients of a valid pattern. It is preceded by a good rally, and the bar itself is wide and encompasses several other bars. It also opened in the direction of the then-prevailing trend and closed on its low.

  CHART 10.3 NASADQ 100 Outside Bars

  The question naturally arises as to why it failed. One explanation is that in really strong uptrends or downtrends, one- and two-bar pat
tern reversals represent contratrend signals, and contratrend signals often result in whipsaws. Note that in this case, the outside bar was the market’s attempt to close a gap that had opened up several trading days earlier. The lower part of the bar, therefore, reached a support area.

  In addition, it’s important to remember that we are dealing in probabilities, not certainties, in technical analysis. Failures can and do exist. That’s why it is always necessary to look over your shoulder and mentally rehearse where you are going to get out should the low-probability losing scenario develop. In this case, the stop would be placed above the upper point of the outside day.

  The second outside bar canceled out a bearish outside bar that had formed 2 days earlier. Usually, cancellations are followed by a pretty strong move, and this example was no exception as the price rallied sharply in mid to late November.

  Major Technical Principle Not all one- and two-bar patterns are followed by a reversal in trend. Some, for example, may be followed by a change in trend.

  Inside Bars

  Inside bars are the opposite of outside bars, in that they form totally within the trading range of the preceding bar. An outside bar indicates a strong reversal in sentiment, but an inside one reflects a balance between buyers and sellers following a sharp up or down move, which is usually later resolved by a change in trend. During the period preceding the second bar of this formation, buyers or sellers have everything going their way, depending on the direction of the trend. Then a more even balance sets in during the formation of the inside bar, which then gives way to a trend in the opposite direction. Examples of inside bars are shown in Figures 10.4 and 10.5.

  FIGURE 10.4 Bearish Inside Bars

  FIGURE 10.5 Bullish Inside Bar

  Guidelines for determining the significance of an inside bar are as follows:

  1. The sharper the trend preceding the pattern, the better.

  2. The wider the first bar and its immediate predecessors in relation to previous bars, the better. This brings the strong underlying momentum of the prevailing trend to a sort of climax.

  3. The smaller the inside bar relative to the outside bar, the more dramatic the change in the buyer/seller balance and, therefore, the stronger the signal.

  4. Volume on the inside bar should be noticeably smaller than that of the preceding bar since it indicates a more balanced situation.

  Chart 10.4 shows an example of an inside bar for Rockwell Collins. It is preceded by a very wide bar, which culminates the December 2011–January 2012 rally.

  CHART 10.4 Rockwell Collins Inside Bars

  Normally, we would expect to see that wide bar experiencing a bigger difference between a relatively low opening and a much higher close, so the small difference between them hinted at a change in balance between buyers and sellers. That was confirmed by the inside bar for which volume and volatility were much reduced. Note also the two small outside bars that signaled the start and end of a small December rally. Chart 10.5 shows many technical events, including an inside bar just prior to the start of a major rally.

  CHART 10.5 Dow Jones UBS Commodity ETN Inside Bars

  Sometimes these characteristics develop at a time when longer-term forces are poised for a major up thrust, and that was obviously the case here because there was no way to tell from the inside bar itself that such a robust advance would follow. Note also that the ranging action that preceded the inside bar was influenced by two outside bars at A and B. Remember these patterns are expected to have an effect for only 5 to 10 bars, so these, which triggered 3-day rallies, came up a little short. Finally, the bearish outside bar that developed in early March 2012 possessed very strong characteristics. First, it whipsawed above the trendline joining the two previous highs. Second, it encompassed many previous days of trading, and third, it closed near to its low.

  Two-Bar Reversal

  A two-bar reversal is classic way in which the charts signal exhaustion. These patterns develop after a prolonged advance or decline. Examples are shown in Figures 10.6 to 10.8. The first bar of the formation develops strongly in the direction of the then-prevailing trend.

  FIGURE 10.6 Bearish Two-Bar Reversal

  FIGURE 10.7 Bearish Two-Bar Reversal Comparing Trading Ranges

  FIGURE 10.8 Bullish Two-Bar Reversal

  For a “five-star” signal in an uptrend, we need to see the close of the bar at, or very close to, its high. At the opening of the next period, buyers come in expecting more of the same.

  This means the price should open very close to the high of the previous bar. However, the whole point of the two-bar reversal is that a change in psychology takes place as the bar closes slightly above or slightly below the low of the previous bar.

  Hence, the high expectations of participants at the opening of the bar are totally dashed at the end of the period indicating a change in trend. To be effective, this has to be a climactic experience. This means that the two-bar reversal should contain as many of the following elements as possible:

  1. It needs to be preceded by a persistent trend.

  2. Both bars should stand out as having exceptionally wide trading ranges relative to previous bars.

  3. The opening and closing of both bars should be close to their extremities.

  4. An expansion of volume on both bars enhances the concept of a change in sentiment.

  5. Heavier volume on the second bar relative to the first emphasizes the preponderance of traders acting in the direction of the new trend.

  6. Since a two-bar reversal ideally should indicate an abrupt change in sentiment, ideally they should not be followed by much in the way of a retracement move.

  Chart 10.6 features a 5-minute bar for the S&P Composite, where we see a classic pattern, with the highs and lows falling at exactly the correct points following a good rally.

  CHART 10.6 S&P Composite Two-Bar Reversal

  Note also that the second bar slightly exceeds the trading range of the first. This outside bar element adds a bearish factor to the pattern.

  Chart 10.7 shows a two-bar reversal at the climax of a rally in U.S. Bancorp in the fall of 2000. Note how the volume expands dramatically.

  CHART 10.7 U.S. Bancorp 2000 Two-Bar Reversal

  Also, volume on the second day was slightly higher than that on the first, thereby providing an additional clue that the tide had turned in favor of the sellers.

  Finally, Chart 10.8, featuring FX Energy, shows how two-bar reversals sometimes form as whipsaws, where the closing of the initial bar and the opening of the second one temporarily move through a support or resistance level.

  CHART 10.8 FX Energy Two-Bar Reversals

  In Chart 10.8, this happens to be resistance, as all those who went long during the formation of the two-bar reversal are trapped below the resistance trendline. This kind of situation is typically followed by an above-average decline and vice versa with a downside whipsaw.

  These one- and two-bar price patterns generally have an effect for a very short period of time. They are not, therefore, suitable for long-term investors. However, for traders who are looking for clear-cut entry and exit points, they can be of immense value.

  Key Reversal Bars

  A key reversal bar is one that develops after a prolonged rally or reaction. Often, the trend will be accelerating by the time the price experiences the key reversal bar. The classic pattern has the following characteristics:

  1. The price opens strongly in the direction of the prevailing trend.

  2. The trading range is very wide relative to the preceding bars.

  3. The price closes near or below the previous close (or near or above the previous close in a downtrend reversal).

  4. Volume, if available, should be climactic on the key reversal bar.

  Examples of key reversal bars are featured in Figures 10.9, 10.10, and 10.11. In many cases, a retracement move follows a key reversal bar, especially if the initial reversal in trend is unduly sharp. Normally, the extreme point of the reversal ba
r is not exceeded.

  FIGURE 10.9 Bearish Key Reversal Bar

  FIGURE 10.10 Bearish Key Reversal Bar Showing Retracement

  FIGURE 10.11 Bullish Key Reversal Bar

  Chart 10.9 shows a classic example in the left part of the chart, as the short-term rally is climaxed by an explosion of volume and a wide key reversal bar.

  CHART 10.9 Barrick Gold 1999–2000 Key Reversal Bar

  Quite often, a key reversal is followed by a sharp change in trend and a subsequent retracement. That is exactly what happened in this case as the price rallied in the fourth and fifth session following the key reversal. Note that the termination of this brief advance was signaled by an outside bar.

  The second example of a key reversal to the right is also a good one, in that volume expands along with the trading range. However, it is not preceded by much of a rally and would not, therefore, earn as many stars as the first one.

  Exhaustion Bars

  Exhaustion bars develop after a really sharp up or down move. They are a form of key reversal but differ sufficiently enough to warrant their own category.