Technical Analysis

When we discussed trends and drawing trendlines in the previous chapters we learned about intermediary and minor trends. And we saw about drawing flat trendlines along with rising or falling trendlines. During the intermediary trend, generally, the price movement will create some patterns which could be indicating either a reversal in the trend or continuation of the existing trend. And usually, the patterns so formed can be easily identified with the help of the trendline. In this chapter, we will discuss widely used reversal patterns and continuation patterns and we will see how to identify the patterns using trendlines.

Reversal Patterns

Reversal patterns are the ones that indicate an impending change in the current trend. A trend either rising or falling should be existing prior to the formation of a reversal pattern. We will see more of the reversal patterns as we discuss the three most reliable and widely used reversal patterns.

Usually, when a trend is about to change, the prices move in such a manner that a pattern takes place on the chart which is identified as reversal patterns. The important prerequisite of reversal patterns are:

• There should be a prior trend
• Consolidation at a certain price range
• A breakout of the pattern should occur
• Traded volume on the breakout day should be high

Keeping the above prerequisites now let us delve into each of the three reversal patterns.

Head and Shoulders

Head and Shoulders is one of the most common and reliable major reversal patterns. This pattern occurs either at the top after an uptrend or at the bottom of a downtrend. Either way, it is the most powerful reversal pattern. The name suggests, the patterns have a head and two shoulders. When it is formed at the bottom, it will be the mirror image and it is known as inverted head and shoulders.

The below chart shows the head and shoulders formed at the top of an uptrend.

In the above chart, you find a head and two shoulders in the formation. The formation to be an ideal one, however, it has to be confirmed by the traded volumes. H&S formation should have the following steps with volume as given below:

• Formation of the left shoulder with high volume
• Formation of the head with volumes less than left shoulder volume
• Formation of the right shoulder with noticeably less volume

After the formation of a head and shoulder pattern, trade can be initiated once the prices break out of the formation. In a H&S, the neckline that is drawn connecting the bottoms of the two shoulders will be the level to watchout for the breakout. In the above chart, you can see the prices breaking below the neckline and it is at this level a trader can initiate a short trade.

Price Target

Price targets can be easily identified on the breakout of a chart pattern. In a H&S, the price target on a breakout will be the distance between the head and the neckline at which the breakout occurs. Suppose, the head is at a price level of 100 and the neckline breakout occurs at 90, the distance between 100 and 90 is 10. So, you can expect the price to fall by 10 Rs. from 90 to 80. You can set your target price at 80 if you have initiated a short trade at 90 where the neckline was penetrated.

I strongly recommend to watch the video on how to trade the “Head and Shoulders” pattern here.

Inverted Head and Shoulders

Inverted head and shoulders occur at the bottom of a downtrend. This is just the mirror image of the top head and shoulders formation. Here the neckline is drawn connecting the top of the head and right shoulder. H&S formed at the bottom has bullish implication and a long trade can be initiated once the price break above the neckline.

Below is a chart that exhibits H&S at the bottom

In the above chart, you can notice the formation of H&S supported by the required volumes to confirm the strength of the pattern.

Rounding Tops & Bottoms

Rounding tops and bottoms are patterns that occur at the end of an uptrend and downtrend respectively. They are extensive movements that can last between months indicating a gradual change in the trend.

Rounding Bottom

In a rounding bottom, the first part will exhibit a diminishing price supported by diminishing volumes. And the last part will be accompanied by a rise in price and volumes.

The below chart shows the rounding bottom

In the chart, you can notice the volumes are very less and gradually increased during the last part of the formation of rounding bottom as the price increases.

This pattern is more significant if it occurs after an extensive downtrend. When the rounding saucer pattern is formed, the outcome advance move will generally be in a gradual manner but it gives a substantial gain to the investors.

Rounding Top

Rounding top is significant if it occurs after an extensive uptrend. During the formation, the volume will generally be irregular or high in the rounding top pattern. This you can see in the below chart which shows a rounding top.

On completion of the pattern, the price tends to fall in a gradual manner as it is in the case of rounding bottom.

Double and Triple Tops and Bottoms

Double and Triple Tops and bottoms signify major reversals. As with any reversal pattern, there should exist a prior trend to these patterns.

Double and Triple Tops

Double tops are formed when an uptrend in prices halts and retraces, and again resumes its uptrend and starts declining after reaching the previous top where it started to retrace earlier. If the price tests its previous high once before falling again, it is said to have made a double top. If the price tests its previous high twice it is said to have made a triple top.

The double top on a chart looks like the below

The triple top on a chart looks like the below

Breakout and price target in double and triple tops

Trade can be initiated once the price breaks out of the formation. The lowest level of the formation will be the support level and breach of this level with high volumes will open an opportunity for a short trade.

On breakout below the support level, the price tends to fall further and a trader can expect a target level that is equal to the distance between the high and low point of the formation.

For example, if the double or triple top point is at 100 and the price level at which the stock retraced to before resuming the up move again is 90 which will also be the support, the difference of 10 between these two levels can be set as targeted move. So, if the price breaks the support level of 90, then the trader can go short and set a target at 80 (90 minus 10).

Double and Triple Bottoms

Double and Triple bottoms signal an intermediate or long term change in the direction. Double or triple bottoms occurs after a downtrend when the fall in price is halted by a short rally. The short term rally reverses to test the previous low. When it tests the previous low once and rises again it will form a double bottom and if the price tests the previous low twice, it will form a triple bottom. Let us see this in a chart.

Below is the double bottom chart

Below is the triple bottom chart

Breakout and price target in double and triple bottoms

In both the above charts you can see the breakout above the resistance level where the prices advanced before falling again to the previous low. You can also see the prices trending up on the breakout of the pattern. The breakout should, more importantly, be accompanied by increased volume to make it a more strong and reliable reversal pattern. Please note that volume is more important in the case of double and triple bottom breakouts than it is for top breakouts.

The target price one can expect on breakout will be the distance between the low and the peak of the short rally added to the breakout point. For example, if the low is 100 and the peak of the short rally is 110, then the distance is 10. And when the price breakout of the pattern at 110, one can expect a target of 120 (110 plus 10).

Continuation Pattern

Continuation patterns are formed when the price moves sideways after an uptrend or downtrend. Generally, continuation patterns indicate that the current trend either rising or falling will be continued after a short term sideways movement in the price. The widely used patterns are triangles, flags, and pennants which we will be discussing in this section.

Triangles

Among the continuation patterns, the triangle pattern can be seen in the chart quite often. Triangle patterns are of four types. They are:

• Ascending triangle
• Descending triangle
• Symmetrical triangle
• Broadening triangle

Triangles can be identified by drawing the upper trendline joining the tops and lower trendline joining the bottoms. By drawing the trendline we can easily identify it as anyone of the above-mentioned triangle type.

Ascending triangle

In an ascending triangle, the trendline drawn joining the tops will be almost a horizontal line and the trendline drawn joining the bottoms will be sloping upward. A long trade is initiated once the price breaks above the top trendline. And a short trade is initiated once the price breaks below the lower trendline.

Descending triangle

In a descending triangle, the trendline drawn joining the tops will be sloping downward and the trendline drawn joining the bottoms will be a horizontal line. In a descending triangle, one can enter into a short trade if the price breaks below the lower trendline. Note that the downside breakout of a descending triangle makes the downtrend stronger.

Symmetrical triangle

In a symmetrical triangle, the trendline drawn joining the tops will be sloping downward and the trendline drawn joining the bottoms will be sloping upward. There will be a convergence of both the trendlines with equal slope. If the slopes are not equal, it will look like either descending or ascending triangle.

Broadening triangle

In a broadening triangle, the trendline drawn joining the tops will be sloping upward and the trendline drawn joining the bottoms will be sloping downwards. The broadening triangle is rather a difficult pattern to trade as the price continues to make higher tops and lower bottoms during the course of its making.

Volume, Duration and Breakout and Price Target on Triangles

Usually, the volume will be less during the formation of triangle patterns and it expands at the breakout. High volume is important especially on a bullish breakout than a bearish breakout.

Except for the broadening triangle, the trendlines drawn to identify the triangle type converges at one point and that point is called the “apex” of the triangle. Usually, the breakout of the price out of the triangle formation occurs during the two-thirds time span of the total time span of the triangle formation. If a breakout does not occur within the time span it may lose its importance and price may continue to move sideways.

The target price on the breakout of the triangle will be the height of the triangle formation added to the breakout price. For example, if the height of the triangle is 10 and the breakout level is at 30, then a trader can expect the price to move up to 40 (30+10).

Flag and Pennants

Flag and Pennant patterns are the ones formed when there is a pause in either rising or falling trend. The price moves sideways in a narrow range and lasts for only 1 to 12 weeks. These patterns can be identified by drawing an upper trendline joining the tops or a lower trendline joining the bottoms. In a pennant formation, the upper and lower trendline converges and whereas in a flag formation, the upper trendline and lower trendline does not converge. You can see this in the below charts.

A chart with a flag pattern

A chart with pennant pattern

In both the flag and pennant patterns, the existing trend either rising or falling is resumed once the price breaks above or below the trendline respectively. Usually, the breakout is accompanied by high volume and the extent of up move or down move can be expected to be significant.

It is important to note that when a flag pattern is extended beyond 12 weeks, it becomes a rectangle pattern and a pennant if extended beyond 12 weeks, the formation becomes a symmetrical triangle.

One distinct characteristic of flag and pennant is the flagpole. A flag or pennant is generally preceded by a sharp rise or fall in prices which looks like a flagpole almost a vertical line. This is highlighted in the above charts.

Key points to remember

• Chart patterns are of “Reversal Patterns” and “Continuation Patterns”
• Reversal patterns are the ones that indicate an impending change in the current trend. A trend either rising or falling should be existing prior to the formation of a reversal pattern
• Powerful reversal patterns are “Head & Shoulders”, Double & Triple tops & bottoms”, and Rounding tops & bottoms”.
• All these three patterns occur either at an uptrend or in a downtrend.
• These patterns are more significant if it is accompanied by high volumes.
• A trade can be initiated in these patterns once price beaks out of the formation.
• Continuation patterns are formed when the price moves sideways after an uptrend or downtrend. Generally, continuation patterns indicate that the current trend either rising or falling will be continued after a short term sideways movement in the price
• Triangles and “flag & Pennants” are widely used continuation patterns
• Continuation patterns are generally identified by drawing trendlines
• A trade can be initiated once the price breaks the trendline either way.

Round Up

The price patterns discussed in this chapter are based on the Dow theory and these have proved to be the reliable price patterns. Traders find these patterns useful in identifying the target and stop loss levels as well.

 

Suggested readings

“Technical Analysis of Stock Trends” by Robert D Edwards & John Magee