Tips on Technicals - Measuring the Move
When a market breaks out of a technical trading pattern, traders need to correctly gauge potential price moves against the risk of being wrong. Most patterns reveal the market's intentions in their own shapes and sizes. Two, and sometimes three, price targets can be revealed with a simple assessment of the pattern itself. This chapter will expand on the measuring concept introduced in the previous chapter.
Sizing up a pattern
The first step in determining where a market is heading is to correctly define the current trading pattern. The easiest pattern to define is the rectangle, or trading range, because of its uniform size.
In theory, the bottom of a rectangle is the price level at which buyers have decided that the market is undervalued. They are either reacting to changes in market sentiment, as indicated by a break above resistance, or following an existing trend higher. Price moves towards the top of the rectangle where profit taking occurs. This moves the market towards the bottom again.
Of course, at this time the rectangle pattern is not yet evident. Figure 1 shows the MATIF French Bond September 1991 futures contract entered a rectangle pattern in July 1991. In this case, the market's decline ended at the bottom of the rectangle where short sellers took profits. The market moved higher until new short sellers found a second chance to sell. Again, prices fell to the bottom of the pattern.
What is different about this bottom is that new buyers had a second chance to buy at the previous low price. It is this cycle of second and third chances that drives the market up and down until finally the market breaks above or below the rectangle. Traders then assume that the old area of value is no longer correct, and in the case of the French Bond, the rectangle area was now too cheap.
The rectangle measured approximately 150 basis points from top to bottom. Buyers at the breakout were assuming buying at this new value area would produce a similar profit as it did in the old area. That translated into an upside target of 150 basis points to 107. This price was reached in a few weeks and proved to be a resistance area.
Coiling Patterns
Most patterns require more interpretation than rectangles. For example, a head and shoulders pattern1 is measured from the neck line to the top of the head. Where the neck line is placed and how much of a tilt it is allowed is up to the analyst.
One pattern that is somewhere in between these two is the triangle and this includes all variations of the triangle such as wedges, pennants, ascending, etc. A triangle is essentially a trading range that is getting smaller over time (coiling). Sellers do not wait for the previous peak to be reached before selling. Conversely, buyers do not wait for the previous bottom to be reached before buying. This cycle continues until the distance between the highs and lows is relatively small and both sides become unsure of the market's future direction.
Figure 2 on the previous page shows the CBT US Bond June 1996 futures contract in a triangle pattern at the end of 1995. The market traded to the triangle's borders several times during that 10 week period so the pattern was well defined. The question is where to measure the height of the pattern.
The best place to measure is at the point of the second border touch. In this case, the second touch is the peak in early January. The distance from that point to the other border can be considered to be the height of the pattern.
Once the market breaks out of the pattern, the pattern height just measured is projected down from the breakout point. This becomes the first trading target. For US Bonds, the pattern height was about 4 points. The break occurred near 116'16 (116 1/2) so the first target was 114'16 (114 1/2). This level was reached within two weeks and proved to be a support zone.
Integral Multiples
The most interesting aspect of pattern projection is that if prices break through the support or resistance supplied by the target price, they often move to a new target that is an integral multiple of the pattern height. US Bonds broke through support at 114'16 and moved another 4 points to support at 110'16 (110 1/2).
In rare cases, a market can move to a third multiple. However, the third occurrence of many projections, whether multiples of a pattern height or the recurrence of the same pattern over time, often has a variation. In this case, the target was not quite reached. Perhaps the short sellers were covering early the same way they did in the coiling pattern. In any event, pattern measuring revealed clues as to where the market wanted to go.
1 See chapter "Bar Chart Patterns"
