Tips on Technicals - Bar Chart Patterns
Support and Resistance
Support and resistance levels can be found in all time frames, from tick to daily to monthly and longer. Simply stated, they are respective price levels at which prices stop going down or up. A price in any market is one at which buyers and sellers have agreed upon fair value. If more buyers think that price is fair, they will attempt to buy. This, in turn, raises demand and prices rise. As prices rise, buyers become less active and sellers become more active.
At some point, buyer and seller activity will balance and this price level becomes resistance. The more times a market touches a resistance (or support) level, the more significant it will become.
There are several important rules with regard to support and resistance. The first is that clear penetration of a well-defined support or resistance level results in a selling or buying opportunity, respectively.
Next, the longer a support or resistance level remains intact, the more important it becomes. On a chart, the more times that prices trade to the top or bottom of the range, the more significant the range boundaries become.
Continuation Patterns
Just like an automobile heading out for a long journey, trending markets need to rest occasionally to refuel. These "rest stops" are called congestion zones. Congestion zones are price levels where the bulls and the bears are taking their profits, licking their wounds and rethinking their strategies.
Rectangles
A rectangle pattern is simply a region bound by a support line on the bottom and a resistance line on the top. The market trades up and down between these two levels for a number of periods (these periods can be days, weeks or even ticks), depending on the type of chart being used.
Figure 1 (below) shows a weekly chart of the US Dollar Index from early 1989 to late 1991. Here, the market was falling from mid-1989 until it entered a rectangle pattern. Note that the last rally attempt within the rectangle failed to reach the top boundary. This is a sign of weakness in the market and is a very good indication that the trend will continue lower.
It is important to let the market prove that the rectangle is a continuation pattern by letting it actually break out. Rectangles and the other patterns described below usually break in the direction of the original trend but not all of the time.
Triangles
This type of continuation pattern has converging lines of support and resistance. Some traders refer to triangles as "coils" because the trading action gets tighter and tighter until the market breaks out with great force. Again, the breakout usually, but not always, occurs in the direction of the original trend. The triangle highlighted in the US Dollar Index had a very strong breakout lower (Figure 1). The declining price range in triangles makes "buying volatility" a very good options strategy (buying volatility involves buying combinations of options such that the trader profits from large moves in either direction).
Triangles come in several varieties. The US Dollar chart (fig. 1) shows a symmetrical shape. An ascending triangle (fig. 2) has a relatively flat top boundary with a rising bottom boundary. Conversely, a descending triangle (fig. 3) has a relatively flat bottom boundary and a falling top boundary. Both the ascending and the descending triangles point in the direction of the likely breakout.
Another important point to keep in mind when analyzing triangles is that a breakout is significant if it occurs approximately 2/3 of the way from the left side of the triangle to the apex (the apex is where the two lines would meet if they were extended). If the price action continues to bounce around in the triangle close to the apex a breakout is less significant and other technical indicators should be used.
Flags
The most common of the continuation patterns is called a flag because it resembles a flag flying on a flagpole. When a market is trending higher, it is more common for it to slowly give back some of those gains as the bulls take some profits. The chart displays a small counter trend lower. When this is over, the market generally breaks out in the direction of the original trend as the bulls re-take their long positions and new bulls enter the market at the new attractive price level.
The CME December S&P 500 (fig. 3) fell sharply on 21 September due to the news of political unrest in Russia. Even during this fast market trading, prices staged a rebound as some of the bears took their profits and some bulls came in to buy at the lower price, thinking that the market had gone down enough. Prices eventually broke out lower than the flag and the market continued to plummet.
Cup with Handle
The cup with handle pattern combines several aspects of other analysis into a reliable continuation indicator. See the "Cup with handle" chapter in part II for the details
Reversal Patterns
Head and Shoulders
One of the most widely recognized reversal patterns is the Head and Shoulders which is named for its resemblance to a head with two shoulders on either side. This pattern demonstrates several technical factors such as failure and trend breaks.
For example, in a rising market, prices make higher highs and higher lows as the trend continues up. Prices rise to the top of the left shoulder and fall in a normal retracement (correction). The bottom of the shoulder is called the "neckline" but it is too early in the analysis to determine this yet.
Next, prices rise to the top of the "head." The significance here is that this is the final push in the rally. A momentum indicator will most likely be falling at this time. As prices fall back, they now fail to set a higher low and should fall back to the neckline.
To summarize what has happened so far, momentum is falling, prices failed to make a higher low and the retracement after the head has most likely broken a trend line. At minimum, it has formally defined the neckline as a support line.
As the market once again attempts to make a higher high, momentum decreases further. Prices fail to reach even the previous high (the head). The weaker the market, the smaller the right shoulder. When the neckline is broken to the down side, the pattern is completed and a reversal occurs.
The daily chart of the cash Australian Dollar (fig. 4) shows an inverted head and shoulders in a falling market. Note that the RSI is rising. The right shoulder had broken the downtrend line in mid-July and currently has broken above the neckline, completing the pattern.
Double Tops and Bottoms
Another important reversal pattern is the double top (or double bottom). This is essentially a head and shoulders without the head. One important difference is that while a head and shoulders is more dramatic, it is also less strict in its definition. The neckline need not be horizontal but can be on an angle. The double top and bottom requires that it be based on a true support or resistance level.
The weekly chart of the Australian Dollar shows (fig. 5) a double bottom that formed over eight months. Prices corrected from their January lows to their April highs. Note that these highs met resistance at a previous congestion zone formed a year earlier (support becomes resistance). The June lows matched those from January and prices are currently rising. The technician would wait until the two-year old downtrend line is broken before buying. Other confirming indicators are an increasing RSI and the inverted head and shoulders bottom in the daily chart which formed the second bottom in the weekly chart.
This pattern requires patience because prices have two hurdles to overcome before a long-term trend can be established. First, the current downtrend must be broken. If it does, this market is likely to rise to the previous highs of April. Next, it must break that resistance level. If it does not, the double bottom did not do its job. Chart patterns by themselves can be misleading so confirmation is required.
Divergence
Divergence on a chart exists when the relative trends of price and of studies are moving in different directions. For example, if the price of Gold is making higher highs (trending higher) and an oscillator study on Gold is making lower highs (trending lower), a bearish divergence exists. Divergence can be bullish or bearish, depending on the relative directions of the price and studies. Typically, divergences are resolved when the price moves in the direction of the study.
In Figure 6, the SIMEX Nikkei Index was making lower weekly lows throughout the first half of 1992. In June, the Relative Strength Index (RSI) did not make a lower low. Again, in August, the RSI actually made a higher low. The Nikkei Index soon reversed direction and began a six month rally.
In figure 7, the money flow for Exxon stock showed a steady increase for two years. Throughout that period, the price of Exxon moved significantly away from the money flow line and each time the price of the stock moved back in the direction of money flow. As is evident in March 1992, December 1992 and January 1993, price moved fairly quickly for a fast profit. For divergences in overlays, such as money flow, look for times when the relative direction of the two lines are different. The absolute divergences are not significant, only the relative shapes of the lines.
