Example of a rising support line becoming resistance.
Usually a support line will function as a resistance barrier on subsequent
rallies, after it has been broken on the downside.
Very often a down trendline will become a support line once it's been
broken on the upside.
FAN PRINCIPLE
The breaking of the third trendline signals the reversal of a trend. Notice
also that the broken trendlines 1 and 2 also become resistance lines.
The fan principle at a bottom. The breaking of the third trendline signals
the upside trend reversal. The previously broken trendlines (1 and 2) also
become support levels.
The failure to reach the upper end of the channel is often an early warning
that the lower line will be broken. Notice the failure to reach the upper
line at point S is followed by the breaking of the basic up trendline at point
6.
Figure 4.18
When the upper channel line is broken (as in wave 5), many chartists will
redraw the basic up trendline parallel to the new upper channel line. In
other words, line 4-6 is drawn parallel to line 3-5. Because the uptrend is
accelerating, it stands to reason that the basic up trendline will do
likewise.
Figure 4.19
When prices fail to reach the upper channel line, and a down trendline is
drawn over the two declining peaks (line 3-5), a tentative channel line can
be drawn from the low at point 4 parallel to line 3-5. The lower channel
line sometimes indicates where initial support will be evident.
Figure 4.20a Prices often retrace about half of the prior trend before
resuming in the original direction. This example shows a 50% retracement.
The minimum retracement is one-third and the maximum, two-thirds of
the prior trend.
Figure 4.20b The three horizontal lines mark the 38%, 50%, and 62%
retracement levels measured from the April 1997 low to the August high.
The 'first decline fell to the 38% line, the second decline to the 62% line,
and the third near the 50% line. Most corrections will 'find support in the
38% to 50% retracement zones. The 38% and 62% lines are Fibonacci
retracements and are popular with chartists.
Figure 4.21a Examples of speed resistance lines in an uptrend.
The vertical distance from the peak to the beginning of the trend is divided
into thirds. Two trendlines are then drawn from point 1 through points 2
and 3. The upper line is the 2/3 speedline and the lower, the 1/J. The lines
should act as support during market corrections. When they're broken,
they revert to resistance lines on bounces. Sometimes these speedlines
intersect price action.
Figure 4.21b Speedlines in a downtrend.
Each time a new high is set in an uptrend or a new low in a downtrend, a
new set of lines must be drawn (because there is now a new high or low
point). Because the speedlines are drawn from the beginning of the trend
to the one-third and two-thirds points, those trendlines may sometimes
move through some of the price action. This is one case where trendlines
are not drawn under lows or over highs, but actually through the price
action.
Figure 4.21c Internal trendlines are drawn through the price action
connecting as many highs and lows as possible. This internal trendline
drawn along the early 1996 highs provided support a year later during the
spring of 1997.
These are variations of the trendline that don't rely on extreme highs or
lows. Instead, internal trendlines are drawn through the price action and
connect as many internal peaks or troughs as possible. Some chartists
develop a good eye for this type of trendline and find them useful. The
problem with internal trendlines is that their drawing is very subjective;
whereas the rules for drawing of more traditional trendlines along the
extreme highs and lows are more exact. (See Figure 4.21c.)
A reversal day takes place either at a top or a bottom. The generally
accepted definition of a top reversal day is the setting of a new high in an
uptrend, followed by a lower close on the same day. In other words, prices
set a new high for a given up move at some point during the day (usually
at or near the opening) then weaken and actually close lower than the
previous day's closing. A bottom reversal day would be a new low during
the day followed by a higher close.
Figure 4.22c The chart action of October 28, 1997 was a classic example of
an upside reversal day or a "selling climax." Prices opened sharply lower
and closed sharply higher. The unusually heavy volume bar for that day
added to its importance. Two less dramatic upside reversal days (see
arrows) also marked price bottoms.
Figure 4.23a The three types of gaps. The breakaway gap signalled the
completion of the basing pattern. The runaway gap occurred at about the
midway point (which is why it is also called the measuring gap). An exhaus-
tion gap to the upside, followed within a week by a breakaway gap to the
downside, left an island reversal top. Notice that the breakaway and run-
away gaps were not filled on the way up, which is often the case.
Figure 4.23b The first box shows an "exhaustion" gap near the end of the
rally. Prices falling below that gap signalled a top. The second box is a
"Measuring" gap about halfway through the downtrend. The third box is
another "exhaustion" gap at the bottom. The move back above that gap
signalled higher prices.
Figure 4.23c The two gaps on this daily chart form an "island reversal" top.
The first box shows an up gap after a rally. The second box shows a down
gap three weeks later. That combination of gaps usually signals an
important top.
The Island Reversal
This takes us to the island reversal pattern. Sometimes after the upward
exhaustion gap has formed, prices will trade in a narrow range for a couple
of days or a couple of weeks before gapping to the downside. Such a
situation leaves the few days of price action looking like an "island"
surrounded by space or water. The exhaustion gap to the upside followed
by a breakaway gap to the downside completes the island reversal pattern
and usually indicates a trend reversal of some magnitude. Of course, the
major significance of the reversal depends on where prices are in the
general trend structure. (See Figure 4.23c.)
MAJOR REVERSAL PATTERNS
Figure 5.la Example of a head and shoulders top. The left and right
shoulders (A and E) are at about the same height. The head (C) is higher
than either shoulder. Notice the lighter volume on each peak. The pattern
is completed on a close under the neckline (line 2). The minimum
objective is the vertical distance from the head to the neckline projected
downward from the breaking of the neckline. A return move will often
occur back to the neckline, which should not re-cross the neckline once it
has been broken.
The Need for a Prior Trend
The existence of a prior major trend is an important prerequisite for any
reversal pattern. A market must obviously have something to reverse.
Figure 5.lb A head and shoulders top. The three peaks show the head
higher than either shoulder. The return move (see arrow) back to the
neckline occurred on schedule.
FINDING A PRICE OBJECTIVE
The method of arriving at a price objective is based on the height of the pattern. Take the vertical distance from the
head (point C) to the neckline. Then project that distance from the point where the neckline is broken. Assume, for
example, that the top of the head is at 100 and the neckline is at 80. The vertical distance, therefore, would be the
difference, which is 20. That 20 points would be measured downward from the level at which the neckline is broken.
If the neckline in Figure 5.la is at 82 when broken, a downside objective would be projected to the 62 level (82 - 20 =
62).
Another technique that accomplishes about the same task, but is a bit easier, is to simply measure the length of the
first wave of the decline (points C to D) and then double it. In either case, the greater the height or volatility of the
pattern, the greater the objective. Chapter 4 stated that the measurement taken from a trendline penetration was
similar to that used in the head and shoulders pattern. You should be able to see that now. Prices travel roughly the
same distance below the broken neckline as they do above it. You'll see throughout our entire study of price pat-
terns that most price targets on bar charts are based on the height or volatility of the various patterns. The theme of
measuring the height of the pattern and then projecting that distance from a breakout point will be constantly
repeated.
It's important to remember that the objective arrived at is only a minimum target. Prices will often move well
beyond the objective. Having a minimum target to work with, however, is very helpful in determining beforehand
whether there is enough potential in a market move to warrant taking a position. If the market exceeds the price
objective, that's just icing on the cake. The maximum objective is the size of the prior move. If the previous bull
market went from 30 to 100, then the maximum downside objective from a topping pattern would be a complete
retracement of the entire upmove all the way down to 30. Reversal patterns can only be expected to reverse or
retrace what has gone before them.
Figure 5.2a Example of an inverse head and shoulders. The bottom ver-
sion of this pattern is a mirror image of the top. The only significant differ-
ence is the volume pattern in the second half of the pattern. The rally from
the head should see heavier volume, and the breaking of the neckline
should see a burst of trading activity. The return move back to the neckline
is more common at bottoms.
Figure 5.2b A head and shoulders bottom. The neckline has a slight
downward slant, which is normally the case. The pullback after the
breakout (see arrow) nicked the neckline a bit, but then resumed the
uptrend.
Figure 5.3 Tactics for a head and shoulders bottom. Many technical
traders will begin to initiate long positions while the right shoulder (E) is
still being formed. One-half to two-thirds pullback of the rally from points
C to D, a decline to the same level as the le shoulder at point A, or the
breaking of a short term down trendline (line 1) all provide early
opportunities for market entry. More positions can be added on the
breaking of the neckline or the return move back to the neckline.
Figure 5.4a A triple top. Similar to the head and shoulders except that all
peaks are at the same level. Each rally peak should be on lighter volume.
The pattern is complete when both troughs have been broken on heavier
volume. The measuring technique is the height of the pattern projected
downward from the breakdown point. Return moves back to the lower
line are not unusual.
Figure 5.4b A triple bottom. Similar to a head and shoulders bottom
except that each low is at the same level. A mirror image of the triple top
except that volume is more important on the upside breakout.
Figure 5.4c A triple bottom reversal pattern. Prices found support just
below 12 three times on this chart before launching a major advance. The
bottom formation on this weekly chart lasted two full years, thereby giving
it major significance.
Figure 5.5a Example of a double top. This pattern has two peaks (A and C)
at about the same level. The pattern is complete when the middle trough
at point B is broken on a closing basis. Volume is usually lighter on the sec-
ond peak (C) and picks up on the breakdown (D). A return move back to
the lower line is not unusual. The minimum measuring target is the height
of the top projected downward from the breakdown point.
Figure 5.5b Example of a double bottom. A mirror image of the double
top. Volume is more important on the upside breakout. Return moves
back to the breakout point are more common at bottoms.
Figure 5.5c Example of a double bottom. This stock bounced sharply off
the 68 level twice over a span of three months. Note that the second
bottom was also an upside reversal day. The breaking of resistance at 80
completed the bottom.
Figure 5.5d Example of a double top. Sometimes the second peak doesn't
quite reach the first peak as in this example. This two month double top
signalled a major decline. The actual signal was the breaking of support
near 46 (see box).
Figure 5.5e Price patterns show up regularly on the charts of major stock
averages. On this chart, the Nasdaq Composite Index formed a double bot-
tom near the 1470 level before turning higher. The break of the down
trendline (see box) confirmed the upturn.
Figure 5.6a Example of a false breakout, usually called a bull trap.
Sometimes near the end of a major uptrend, prices will exceed a previous
peak before failing. Chartists use various time and price filters to reduce
such whipsaws. This topping pattern would probably qualify as a double
top.
Figure 5.6b Example of a false breakout. Notice that the upside breakout
was on light volume and the subsequent decline on heavy volume-a
negative chart combination. Watching the volume helps avoid some false
breakouts, but not all.
Figure 5.7a Example of a normal pullback from a previous peak before
resumption of the uptrend. This is normal market action and not to be
confused with a double top. The double top only occurs when support at
point B is broken.
Notice in Figure 5.7a that the price at point C backs off from the previous peak at point A. This is perfectly normal
action in an uptrend. Many traders, however, will immediately label this pattern as a double top as soon as prices fail
to clear the first peak on the first attempt. Figure 5.7b shows the same situation in a downtrend. It is very difficult for
the chartist to determine whether the pullback from the previous peak or the bounce from the previous low is just a
temporary setback in the existing trend or the start of a double top or bottom reversal pattern. Because the
technical odds usually favour continuation of the present trend, it is usually wise to await completion of the pattern
before taking action.
Figure 5.7b Example of a normal bounce off a previous low. This is normal
market action and not to be confused with a double bottom. Prices will
normally bounce off a previous low at least once, causing premature calls
for a double bottom.
