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Final Considerations
We have
discussed the different types of price patterns over the past several
updates. In this section, we shall consider some of the common
features, which will help us to determine the possible outcomes better.
We shall also summarize the topic of patterns and see how one should go
about using this for analysis and trading.
Volumes and Patterns
As discussed
earlier, volumes are an integral part of pattern identification. To sum
it up, the following points may be noted for volumes
Reversal patterns are generally accompanied by
increasing volumes in the expected new direction. In a top head and
shoulder for example, the volumes will be heavy in the decline form the
right shoulder (the new direction being down). In a rounding pattern
bottom, the volumes will be maximum during the rising leg of the
rounding pattern (the new direction being up). In the original
direction, the volumes will begin drying up. |
Continuation patterns usually will have reduced
volumes while the pattern is under formation. Hence a triangle or a
rectangle will have a sharply reduced volume when movements are within
the confines of the pattern trendlines. Any suspected continuation
pattern with high volumes is more prone toward failure. |
| Breakouts from price patterns should be with high volumes. Also, the volumes should persist during the next move. |
The greater the build up of the volume during a
reversal pattern, the larger the expected move in the other direction.
This is especially true for bottom reversal patterns. We do need to see
substantial amount of accumulation before prices can move higher. |
| Breakouts with low volumes are likely to fail. |
Point of Resolution
Every pattern
has a point of resolution i.e a price level which if crossed, one can
state that the pattern has ended and the new expected move has
commenced. This would differ from pattern to pattern. In the head and
shoulder, it is the neckline. In the rounding pattern, it is the top of
the rounding. In the double and triple formations, it is below the
valley low. In the triangles, it is the breakout on either side from
the converging lines going to form the pattern. Similarly in the
rectangle, it will be breakout from the parallel lines, which confine
the pattern. It is the case in the Flags and Pennants and Dynamite
triangles. In these minor patterns, the breakout is most likely to be
in the same direction as that preceded its formation. It is the case in
a Wedge.
The only patterns where there is no precise point of
resolution would be the One day and Island reversal patterns and the
Expanding triangle. In the former, the resolution itself is the
completion of the pattern while in the latter; the pattern is too
diffuse to have a single point of reference.
Targets using Patterns
All patterns
offer the facility of calculating the minimum price target that the
stock would achieve once it is resolved. The target is directly
proportional to the size of the pattern. The pattern size is determined
by the height it reaches. For example, the height in a head and
shoulder pattern is defined as the price difference between the top of
the bar forming the head and the neckline level. In a triangle, the
base of the triangle is the height. The difference between the two
parallel lines in a rectangle is the height of the pattern. In double
and triple formations, the distance between the valleys to the peak is
the height of the pattern.
The way of measuring heights in the
following patterns is slightly different. The entire formation is taken
as the height i.e. from the lowest point of the start of the pattern to
the highest reached within the pattern (vice versa when the pattern is
at the top). These patterns are the Wedge, Flag, Pennant, One-day and
Island Reversal and Rounding. In all of these, identify the first bar
from where the pattern can be begun and measure the distance in price
between this bar and the part where the pattern ends. This will be the
height of the pattern.
All patterns, once resolved, will move
to a minimum distance equal to the height of the pattern. There could
be more but this is the minimum expected target.
A couple of examples of targets are seen in the following charts.
From
some of the examples above it should be sufficiently clear as to how to
calculate the height of the pattern and to project it upward or downward
It
will be found that most of the stocks will come through on the
projected targets. When the trend strength in the new direction is
high, the prices will hesitate around the target area for a while and
then continue in the same direction afresh. One can then calculate a
second length of the height and project it in the same direction. This
is particularly true of rounding patterns.
In our markets, the
rounding pattern is the most common pattern that has been observed and
it has a very high rate of success. At the end of larger trends, we
also find great many examples of inverted head and shoulders pattern.
Triangles are seen less often while rectangles are more common. Flags
and Pennants will be seen only during fast markets and are therefore
more likely to be found in intra day charts. Dynamite triangles are
infrequent. Island and One day reversals are quite rare as are Wedges.
In fact, identifying wedges is quite a difficult job and requires the
practiced eye. Narrow range patterns are very frequent and quite
useful. Outside day patterns coming at the end of long moves should be
respected.
Trading with patterns
It is not
likely that patterns would be seen in every chart. One must therefore
be on the alert to check for the existence of any pattern rather than
suppose that one would find it on a chart. Once a pattern is
identified, one should check whether it is being seen in the correct
position i.e a head and shoulder pattern cannot come at the end of a
decline or in the middle of one; it has to be at the top of an advance.
Key reversal patterns in a sideways range are meaningless. Once the
pattern is confirmed as being a valid one, find its resolution point
and measure the size. Await the breakout and then initiate a trade.
Most people make the mistake of jumping the gun and presupposing the
breakout direction. One comes to grief on this either because the
ultimate resolution takes a long time or the pattern fails. It is
therefore always better to move in after the market has signaled its
intention to continue in the expected direction.
Pattern Failures
There are times
when patterns do not come through as expected. A head and shoulder
pattern where a neck line breaks but then does not move lower and
instead, prices swing back into the original direction is an example of
pattern failure. A triangle, which breaks out upward, only to be
followed by an immediate decline below the lower trendline is also an
example of a failure. One can use volume indications as a possible
safeguard against failures. But the only way it to admit to the failure
and square up the trade initiated on the first break.
It may
be remembered that pattern failures occur in the penultimate stage of a
trend. In other words, the next move after a pattern failure is often
the final top or bottom (as the case may be). In this manner, pattern
failures also give us trading signals! |