Chapter 3 Price Patterns PDF

Chapter 3 PRICE PATTERNS Chapter Outline: 3.1 Smaller Patterns and Gaps 3.2 One and Two Bar Price Patterns 2 3.1 Smaller Patterns and Gaps The concept of price patterns is demonstrated in Figures 8.1 and 8.2. Figure 8.1 represents a typical market cycle in which there are three trends: up, sideways,...

Chapter 3 PRICE PATTERNS Chapter Outline: 3.1 Smaller Patterns and Gaps 3.2 One and Two Bar Price Patterns 2 3.1 Smaller Patterns and Gaps The concept of price patterns is demonstrated in Figures 8.1 and 8.2. Figure 8.1 represents a typical market cycle in which there are three trends: up, sideways, and down. The sideways trend is essentially a horizontal or transitional one, which separates the two major market movements. 3 Sometimes, a highly emotional market can change without warning, as in Figure 8.2, but this rarely happens. Consider a fast- moving train, which takes a long time to slow down and then go into reverse; the same is normally true of financial markets. 4 Transitions between a rising and a falling trend are often signalled by identifiable trading ranges known as price patterns. For example: Figure 8.3 illustrates the price action at the end of a long rising trend. As soon as the price rises above line BB, it is in the transitional area, although this is apparent only sometime after the picture has developed. 5 Types of Reversal Pattern 1. Rectangle The transitional or horizontal phase separating rising and falling price trends discussed earlier is a pattern known as a rectangle. This corresponds to the “line” formation developed from Dow theory. The rectangle in Figure 8.5, marking the turning point between the bull and bear phases, is termed a reversal pattern. 6 Cont.…… Reversal patterns at market tops are known as distribution areas or patterns (where the security is “distributed” from strong, informed participants to weak, uninformed ones), and those at market bottoms are called accumulation patterns (where the security passes from weak, uninformed participants to strong, informed ones. In Figure 8.6 we see a completed pattern with a victory for the buyers as the price pushed through line AA. 7 2. Head and Shoulder Head-and-shoulders top is reversal patterns that form as the price hits a resistance level (forming the first shoulder), then breaks through the first resistance level and hits a higher resistance level (forming the head) and then hits the first resistance level again (forming the second shoulder). Head-and-shoulders bottom is reversal patterns that form as the price hits a support level (forming the first shoulder), then breaks through the first support level and hits a lower support level (forming the head) and then hits the first support level again (forming the second shoulder). 8 Head & Shoulder 9 Volume characteristics are of critical importance in assessing the validity of these patterns. Activity is normally heaviest during the formation of the left shoulder and also tends to be quite heavy as prices approach the peak. The real tip-off that an H&S pattern is developing comes with the formation of the right shoulder, which is invariably accompanied by distinctly lower volume. Quite often, the level of volume contracts as the peak of the right shoulder is reached. The line joining the bottoms of the two shoulders is called the neckline. 2. Double Tops or Bottoms Double tops/bottoms are reversal patterns that form as the price hits a support or resistance level two times before the price turns around and moves in the opposite direction. Double tops are bearish reversal patterns and double bottoms are bullish reversal patterns. If a stock price is in an up trend, it will form a double top. If a stock price is in a down trend, it will form a double bottom. Double tops/bottoms usually form over longer periods of time. 11 Double Tops & Bottoms 12 A double top consists of two peaks separated by a reaction or valley in prices. Its main characteristic is that the second top is formed with distinctly less volume than the first. It is normal for both peaks to form at the same price level, but it is also possible for the second peak to slightly exceed the first or to top out just a little below it. Remember, this is not an exact science, but a common sense interpretation of a battle between buyers and sellers. 13 Double bottoms is typically accompanied by high volume on the first bottom, very light volume on the second, and very heavy volume on the breakout. Usually, the second bottom is formed above the first, but these formations are equally valid whether or not the second reaction reaches (or even slightly exceeds) the level of its predecessor. 14 3. Triple Tops and Bottoms Triple tops/bottoms are reversal patterns that form as the price hits a support or resistance level three times before the price turns around and moves in the opposite direction. Triple tops are bearish reversal patterns and triple bottoms are bullish reversal patterns. If a price is in an up trend, it will form a triple top. If a price is in a down trend, it will form a triple bottom. Triple tops/bottoms usually form over longer periods of time. 15 Triple Tops & Bottoms 16 Types of Continuation Pattern 1. 2. 3. 4. 5. 6. Rectangle Flag Pennant Triangle Wedge Cup and Handle 17 Continuation Patterns Continuation patterns give an advanced warning when a stock price is likely to resume its trend after a short consolidation period and how far the stock price is likely to move in that direction. Of course, continuation patterns are not infallible, but they do put the odds of success in the favor. 18 Rectangle as continuation pattern 19 Flag Flags are continuation patterns that form as the price of a stocks pulls back from the predominant trend in a parallel channel. Flags can be either bullish or bearish, depending on what the trend was before the flag began to form. If a stock price was in an up trend before the flag began to form, it is a bullish continuation pattern. If a stock price was in a down trend before the flag began to form, it is a bearish continuation pattern. Flags usually form over shorter periods of time. 20 Pennant Pennants are continuation patterns that form as the price of a stock moves into a tighter and tighter consolidation range. Pennants can be either bullish or bearish, depending on what the trend was before the pennant began to form. If a stock price was in an up trend before the pennant began to form, it is a bullish continuation pattern. If a stock price was in a down trend before the pennant began to form, it is a bearish continuation pattern. Pennants usually form over shorter periods of time. 21 Bullish & Bearish Pennant 22 23 Triangle Triangles are continuation patterns that form as the price of a stock hits a flat level of support or resistance and begins moving into a tighter and tighter consolidation range. Triangles can be either bullish or bearish, depending on what the trend was before the wedge began to form. If a stock price was in an up trend before the triangle began to form, it is a bullish continuation pattern. If a stock price was in a down trend before the triangle began to form, it is a bearish continuation pattern. Triangles usually form over longer periods of time. 24 Types of Triangles Symmetrical Ascending Descending 25 SYMMETRICAL The symmetrical triangle is a pattern in which two trendlines converge toward each other. This pattern is neutral in that a breakout to the upside or downside is a confirmation of a trend in that direction. 26 27 ASCENDING In an ascending triangle, the upper trendline is flat, while the bottom trendline is upward sloping. This is generally thought of as a bullish pattern in which chartists look for an upside breakout. 28 29 DESCENDING In a descending triangle, the lower trendline is flat and the upper trendline is descending. This is generally seen as a bearish pattern where chartists look for a downside breakout. 30 31 Wedges Wedges are continuation patterns that form as the price of a stock pulls back from the predominant trend and moves into a tighter and tighter consolidation range. Wedges can be either bullish or bearish, depending on what the trend was before the wedge began to form. If a stock price was in an up trend before the wedge began to form, it is a bullish continuation pattern. If a stock price was in a down trend before the wedge began to form, it is a bearish continuation pattern. Wedges usually form over shorter periods of time. 32 Wedges 33 Wedges 34 Cup and Handle A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confirmed. This price pattern forms what looks like a cup, which is preceded by an upward trend. The handle follows the cup formation and is formed by a generally downward/sideways movement in the security's price. Once the price movement pushes above the resistance lines formed in the handle, the upward trend can continue. There is a wide ranging time frame for this type of pattern, with the span ranging from several months to more than a year. 35 Cup and Handle 36