Trading Course: Petterns

Breakaway Gap

A Breakaway Gap is a breakout of a trading range or pattern where the price begins trading above or below the previous range and days price. When the opening price is much different than the previous days closing price a gap forms. The movement indicates a higher enthusiasm to buy or sell the stock depending on the direction of the gap. Traders should realize that a higher enthusiasm to buy or sell any security which occurs suddenly so that a gap in price activity materializes should be scrutinized for the possibility of whipsaws.

The motivated movement in price may last for some time or it may be a single day anomalous reaction to news or event. Traders may see opposing fundamentals emerging for the stock or market in the days following a gap and will use this information to support possible price projections in the event that a reversal of the price trend occurs. Gaps are often closed by future prices if fundamentals support a different outlook. Depending on the degree of enthusiasm and the position of the gap, traders will make price projections to be used if price and volume activity begins to support their outlook. In the event of a reversal of price trend after the formation of a gap, traders often look for prices to close the gap before moving significantly forward.

Alternatively if price begins to consolidate but does not close the gap, it becomes supporting evidence for a continuation of price trend in the direction of the Gap.

In the case of a gap to the upside, where initial enthusiasm results in an opening price far above the previous days closing price, there are arguments for and against trading strategies based on this occurrence. Some traders look for small gains intra-day on the day on which the gap occurred, and then either closing or minimizing the position by the close of the day.

For downside gaps, some strategies call for intra-day trading in the direction of the gapping security while others interpret a gap as a warning signal of diminished demand and implement a trading decision based on that occurrence.

Trade strategies that involve the occurrence of a gap in price action can be risky due to the high potential for a whipsaw or reversal. Other confirming indicators and data should accompany any trading decision when gaps are involved.

For longer trade horizons, gaps can have many different implications and could provide very poor trading results if the security later looses momentum and reverses the trend. A gap in itself is an instance of increased demand or supply that needs to be fully understood prior to becoming a tradable event.

Several gaps in the price plot of the S&P500 Index are the result of strong overnight bias leading into the trading day that results in an opening price that differs from the closing price the day before. When a gap is the result of a breakout from a channel or trading range, as if it is the result of an event or perception of an event that significantly alters supply and demand, it can predict a continuation of that movement.

Cup with Handle

The formation occurs after a trend change, where a series of rising peaks and troughs is followed by a reversal of the price trend. A downtrend of lower peaks and lower troughs form the left side of the cup, rounds out and later begins a new rising trend so that a cup is formed. The cup is in the shape of a “U”. The handle is a drop in prices after the right side of the lip of the cup has been reached. The handle can have a variety of shapes and can consist of double handles and high handles. As long as the price does not fall back through the 200 day moving average in forming the handle, the expectation for the pattern is for prices to rise after completion of the handle.

A breakout from the handle formation is usually accompanied by rising volume and is a positive sign for a continuation of the trend in the direction of the breakout.

Double Top/ Bottom

When price peaks after a rise, and the decline that follows leads to another rise in prices to form a second peak at or about the level of the first peak, a double peak is said to have formed. A neckline can be drawn across the base of the two peaks. A neckline is simply a trendline and penetration through a neckline after a decline from the second peak is a good indication that the price of the tradable will continue to fall. Traders often allow for a 5% penetration through a neckline to avoid whipsaws. Volume is generally greater in generating the first top than in making the second.

A double top is simply two peaks. After the second peak is formed a breakout through the base is a signal of a possible reversal of the trend in prices. In the case of a double bottom, two troughs form and an expectation follows for the possibility of a trend reversal if the market price rises through the base.

Waiting for confirmation is important for trading double tops. Twin peak formations usually show a decline of between 10% and 20% between the peaks. Volume is usually higher on the left peak than on the right peak. The confirmation point is the base of the peaks. A breakout through the baseline is more convincing if accompanied by higher volume and predicts a continuation of the trend in that direction. Price projections can be made by determining the price difference from the neckline to the first peak and then subtracting that value from the price at the time of penetration from the neckline.

Price projections are estimates of the potential near term movement of the price once a breakout has occurred. When the price of the tradable is low, the best approach in making price projections is to use percentages. A percentage difference of 6% between the price at the first peak and neckline would translate into a projected price drop upon penetration of the neckline of about 6% of the price at penetration.

Double Bottom

Flag Pattern

When a stock has a strong run up over a short period of time, where it gains 30% or 40% or more, there is a tendency for either a correction or a continued advance with even larger gains expected. One chart pattern that sometimes precedes a second large advance is called the “high tight flag”. This is a pattern that starts with a flag pole, or price that rises sharply in a short period of time. This is followed by a tight consolidation period that can last between 2 to 6 weeks. The consolidation period creates the formation of a “flag”, a break out of such a consolidation period is usually to the upside and can produce gains similar to the percentage increase of the initial gains made during the creation of the flagpole.

During the formation of the flag in the consolidating period volume generally declines. A breakout from the flag pattern is usually accompanied by increased volumes. Price projections that are estimations based on the range of price during the formation of the flagpole are projected upwards from the flag formation on a breakout give a rough idea of what to expect near term for prices. What price projections do not do is tell you whether prices will reach that level or stay at that level. A projection is simply an estimation based on the increased demand for the stock and a potential for a short term continuation of price surge following a consolidation of prices.

Pattern – Head & Shoulder

Head and Shoulders patterns resemble the upper part of a person’s body, specifically a shoulder on either side of a head. The line connecting the left and right armpit is referred to as the neckline.

After a rise in the market, if a formation that looks like a head and shoulders is forming and price breaks through the neckline after completing the right shoulder, this indicates a possibility that a reversal of the price trend may occur. A head and shoulders pattern can also occur at the market bottom. When it is at a bottom the formation is inverted, like someone upside down.

Volume is usually highest during the left shoulder formation. As prices slip back, volume recedes, when a second rally forms, volume is again high, the head of the pattern is formed when surging prices and volumes begin to ease and fall back again. The trough between the head and the right shoulder must be below the peak of the left shoulder for the pattern to be considered a head and shoulder pattern. The right shoulder is another rally in prices but typically volume is lower than the volume that created the left shoulder and the head. Once the head and shoulders formation is complete, a breakout down through the neckline can be a good indication that the trend of prices will continue in the direction of the breakout.

Price projections are identified by taking the point or percent change (dependent on the price of the security) between the Head and the Neckline. Then, that amount is projecting from the point of penetration of the neckline in the direction of the penetration after formation of the right shoulder. Price projections are only estimates and should accompany other supporting evidence in developing.

Triangular

When price fluctuations stay in a trading range and that trading range becomes progressively smaller with the passage of time a triangle formation occurs. Triangles are hard to use as a forecasting tool but there are some perceptions that follow from this type of formation that give insight into future market action. In the formation of a triangle, resistance and support area’s are identifiable as daily fluctuations move toward the apex. Identifying triangle patterns allows for trading opportunity during formation and after a breakout from the pattern. Uncertainty is the basis or reason behind why each rally and each sell off has less market commitment. At some point that uncertainty is resolved enough or other factors tip the scales of supply and demand for the general market so that a breakout of the pattern occurs. A triangle could signal a reversal or continuation of the trend. The general trend of fundamentals and psychological sentiment in the market play an important role in the unfolding of price action and the resolution of patterns like triangles.

Symmetrical Triangles -

Lines drawn connecting peaks and troughs tend to converge at the apex which is at the center of the pattern. When price breaks outside of the pattern and if accompanied by increasing volume, there is a high probability that the future price will trend in the direction of the breakout.

Ascending Triangles -

A line connecting the peaks is horizontal while the line connecting the troughs rises and converges with the top line as a series of rising troughs meets resistance at the same level. Volume often remains moderate to low throughout the formation of the triangle with marked increases on the breakout.

Descending Triangles -

Troughs form a horizontal line while a series of falling peaks create a line that is a downward sloping resistance line. The indication is that supply becomes more aggressive as sellers lower their valuation perceptions. Breakout is usually to the downside.

In the case of most triangles, the odds are that the trend leading into the triangle continues on the breakout of the triangle. Breakouts can occur usually as soon as 2/3 the distance to the apex through to the apex itself. It is not out of the question, when fundamental indecision and with no change in psychological setting in the market, for the market to continue in a sideways motion through the apex of an earlier triangle formation.

Triangles are subject to many false moves and are among the least reliable of chart patterns. Most traders allow for a 3 to 5% move outside of the pattern before the breakout is considered reliable. When a breakout occurs, the trend that results is expected to be in the direction of the breakout.

Generally, it is a good idea to watch volume when a breakout occurs. A breakout on increasing volume is a good sign for a continuation of the price trend in the direction of the breakout. The intensity of buying and selling pressure and the conviction behind each move can be useful in determining the validity of the break out. But remember that when markets are in a trading range there is a build up of stop loss orders just outside of the pattern, on both sides of the market, that can create volume spikes when a breakout does occur. It is a good idea to have fundamentals and psychological setting supporting the breakout. Price projections can be useful in triangle formations. The price range of the base of the triangle opposite the apex is considered to be a fair estimate of the move that will occur after the breakout from the triangle formation.