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Doğu Akdeniz Üniversitesi Faculty of Business and Economics Department of Banking and Finance Saeed Ebrahimijam FINA417 Spring 2013 This Chapter presents a select group of reversal chart patterns, ones that have proven to have considerable validity over many years: Key reversal pattern Head and Shoulder pattern(top and bottom) Ascending and descending triangles Rectangles Double and triple top and bottom Fundamental of Technical Analysis and Algorithmic Trading 2 A reversal pattern, meaning that it signifies a change in the trend. These patterns, known as reversal chart patterns, help identify when the market is changing direction, either from up to down or down to up. The primary importance of reversal patterns is that they help one sell securities before substantial price declines and cover short sales ahead of considerable advances. Many of the price patterns are based on geometrical figures. Occasionally, more fanciful shapes are seen, such as the head-and-shoulders formation. Fundamental of Technical Analysis and Algorithmic Trading 3 The forming of a market top and subsequent price reversal to the downside occurs as a result of supply overcoming demand (known as distribution). The opposite occurs at market bottoms when demand overcomes supply (known as accumulation). In both cases, this overcoming activity typically occurs gradually. A reversal chart pattern develops as prices move in a sideways fashion of some sort until a complete reversal is accomplished. “ At this time, first, the stock price will fluctuate around a certain level and then the trend changes.” Fundamental of Technical Analysis and Algorithmic Trading 4 Typical Price Action Key reversals occur during one period (usually one day) of market activity. A key reversal top is the result of prices quickly moving higher (to a new high in an uptrend) than the previous period’s high, but closing near the lows of the day (and, at times, even lower than the previous period’s low). Key reversal tops appear regularly in thinly traded stocks after an active advance. The opposite occurs for a key reversal bottom. Prices first move sharply lower (to a new low in a downtrend) than the previous period’s low and then move to the upside closing near the high for the day (and often higher than the previous period’s high). A key reversal bottom is frequently called a selling climax as it often occurs at the end of a panic decline. Fundamental of Technical Analysis and Algorithmic Trading 5 Fundamental of Technical Analysis and Algorithmic Trading 6 Fundamental of Technical Analysis and Algorithmic Trading 7 Typical Volume Action Key reversals normally are accompanied by unusually high volume. Frequency of Occurrence Key reversals appear often. They can develop independently or as a part of a larger chart pattern (such as the top of the head in a head-and-shoulders top formation). Fundamental of Technical Analysis and Algorithmic Trading 8 only short-term (minor trend) significance. Its significance is, however, greatly enhanced if one or more of the following occurs: 1. The period’s high penetrates the previous period’s high significantly for a key reversal top, or the period’s low penetrates the previous period’s low significantly for a key reversal bottom. 2. The key reversal period was preceded by a long, unbroken trend. 3. The period’s closing price was below (for a key reversal top) or above (for a key reversal bottom) one or more immediately prior period ranges. 4. The period volume was particularly high. Fundamental of Technical Analysis and Algorithmic Trading 9 This formation is characterized by two small peaks on either side of a larger peak. H & S Top H ead R ig h t S h o u ld e r L e ft S h o u ld e r N e cklin e H & S B o tto m N e cklin e L e ft S h o u ld e r R ig h t S h o u ld e r H ead Fundamental of Technical Analysis and Algorithmic Trading 10 Fundamental of Technical Analysis and Algorithmic Trading 11 If the price diagram intersect the neck line, this can be a strong signal of change in the overall price trend. The pattern is not completely symmetric always. Fundamental of Technical Analysis and Algorithmic Trading 12 There will be high volume of trading at the left shoulder, when the price is increasing but then while descending price trend the volume of trading decreases, again there will be an increase by price boost and at last after passing from head there will be low volume of trading. Fundamental of Technical Analysis and Algorithmic Trading 13 volume is heavy on the rally portion of the left shoulder. Volume declines on the dip from the left shoulder peak and then again is heavy on the rally up to the top of the head. A reduction in volume occurs on the decline from the top of the head. The ensuing rally to create the right shoulder occurs on less volume than on previous rallies in this formation. For a head-and-shoulders bottom, volume picks up on each rally with greater volume on the rally completing the right shoulder than on the rally completing the head. Between rallies, volume diminishes. If the neckline is broken on relatively low volume, it could indicate a false signal, and a retest of lows may be necessary. Fundamental of Technical Analysis and Algorithmic Trading 14 Upon the break of the neckline support level the chart pattern is said to be in place so this is where traders will commonly look to enter a short position (sell). Their target will be calculated by measuring the distance from the head of the pattern down to the neckline and then projecting that distance downward from the breakpoint of the neckline. The stop loss will then be placed just above the right hand shoulder of the pattern which is considered resistance. The idea here is that once the neckline support has been broken sellers will theoretically remain in control but if this does not happen then you are protected with a stop loss just above the nearest resistance level. For the reverse head and shoulders the strategy is a mirror. Fundamental of Technical Analysis and Algorithmic Trading 15 Estimation of next price level. (price goal) Fundamental of Technical Analysis and Algorithmic Trading 16 Fundamental of Technical Analysis and Algorithmic Trading 17 http://www.newyorkfed.org/research/staff_reports/sr4.pdf Fundamental of Technical Analysis and Algorithmic Trading 18 Triangles are continuation formations. Three flavors: ◦ Ascending ◦ Descending ◦ Symmetrical Typically, triangles should break out about half to three-quarters of the way through the formation. Fundamental of Technical Analysis and Algorithmic Trading 19 - Typical Price Action For an ascending triangle: prices swing between a horizontal top boundary line and an upward or downward sloping bottom boundary line. An ascending triangle develops when demand is growing but continues to meet supply at a certain price level. Once the supply is absorbed, prices break out of the pattern and move up rapidly. For a descending triangle, the opposite is true. Fundamental of Technical Analysis and Algorithmic Trading 20 Reputation of the pattern: Triangles are considered intermediate-term patterns, usually taking from one to three months to complete. These can be recognized in intraday share prices, but less frequent in weakly prices. Fundamental of Technical Analysis and Algorithmic Trading 21 There are good opportunities for profit making. i.e. The Ascending triangle pattern shows bullish state regards to the share, whereas descending triangles shows a bearish state in the market. After creating enough demand and absorbing the supply volume, prices break out of the pattern and suddenly continue uptrend in advance. Fundamental of Technical Analysis and Algorithmic Trading 22 Fundamental of Technical Analysis and Algorithmic Trading 23 Volume decreases as prices move toward the apex of either the ascending or the descending triangle. Breakouts are accompanied by a marked increase in trading volume. Fundamental of Technical Analysis and Algorithmic Trading 24 Ascending and descending triangles offer excellent profit opportunities. The ascending triangle provides a bullish outlook. Descending triangle suggests a bearish future. Fundamental of Technical Analysis and Algorithmic Trading 25 It is recommended not to trade symmetric triangle patterns because they are highly unreliable. Triangles usually break after 2/3 of their size. If the prices went beyond 2/3 of the triangle the breakout will be even less reliably and not recommended to trade. Take trades at the break out of the trend lines, with the Stop-Loss order placed above or below the pattern, or conservatively, it can be placed above or below the breakout bar. The target for this trade is a level equal to the height of the base of the triangle, from the breakout point. Fundamental of Technical Analysis and Algorithmic Trading 26 Fundamental of Technical Analysis and Algorithmic Trading 27 Fundamental of Technical Analysis and Algorithmic Trading 28 Fundamental of Technical Analysis and Algorithmic Trading 29 Fundamental of Technical Analysis and Algorithmic Trading 30 The rectangle is a classical technical analysis pattern described by horizontal lines showing significant support and resistance. Fundamental of Technical Analysis and Algorithmic Trading 31 Fundamental of Technical Analysis and Algorithmic Trading 32 The area within the lines is also known as a trading area or range. Rectangles are formed when there is a consistent supply of a security at a certain price and a demand at a certain lower price. When the price reaches the lower price, the security is purchased, driving up the price until it reaches the upper boundary, and people are ready to sell and drive the price back to the lower boundary. This occurs repeatedly until one side or the other gives way, and the pattern is broken. A closing price outside the upper- or lower-boundary line suggests the direction of the trend. If the closing price is above the upper-boundary line, the probability is that prices will move higher. On the other hand, if the closing price is below the lower-boundary line, prices are likely to fall. Fundamental of Technical Analysis and Algorithmic Trading 33 Volume action can give a clue as to whether the rectangle formation will ultimately be broken to the upside or downside. If volume is relatively higher on upward price swings than on moves to the downside, it is likely that the breakout will occur on the upside. On the other hand, if volume is relatively higher on downward price swings than on moves to the upside, it is likely that there will be a downside breakout of the rectangle Fundamental of Technical Analysis and Algorithmic Trading 34 Fundamental of Technical Analysis and Algorithmic Trading 35 If the close price of a share was higher than upper line or lower than bottom line of rectangle, it can be considered as strong probability of up/downtrend respectively. Fundamental of Technical Analysis and Algorithmic Trading 36 The following are two basic strategies for trading a rectangle: The first, is to buy at support and sell at resistance (one can also sell short at resistance and cover the short sale at support). To mitigate risk, in case the stock breaks down from support, a very tight stop can be employed of perhaps 3%. For example, if one bought ImClone at $37.50, the stop-loss would be 3% lower than $37.50 or $1.12. The trader would exit the position if the stock hit $36.38 ($37.50-$1.12). Second, method to trade the rectangle is to wait for the breakout. As with all technical patterns, this breakout should ideally occur on above-normal volume. To know when to consider exiting the trade, the trader could use the measuring principle described below. (Learn more about volume in Gauging Support And Resistance With Price By Volume.) Fundamental of Technical Analysis and Algorithmic Trading 37 To calculate the minimum target, first establish the height of the pattern. In the case of ImClone Systems Figure shows the calculation as follows: Top: $47.50 Bottom: $37.50 Height: 10.00 points For a bullish breakout, once the height of the pattern has been established, add the difference to the breakout level. Since the breakout level is $47.50 and the height 10 points, the minimum target is $57.50. Of course, it may take some time to reach the target, so the trader must be patient. As well, the measuring principle is a statement of probability, not a guarantee. The trader will carefully monitor the technical picture of the stock despite the target. Fundamental of Technical Analysis and Algorithmic Trading 38 “ Some short-term traders make trades within well-defined rectangles. They buy when prices reach the bottom boundary and sell short when prices reach the upper boundary. To protect themselves in the event of a pattern breakout, each time they buy or sell short, they also place stop-loss orders just outside the lower or upper boundary lines to minimize any potential losses. If the pattern is broken, they are stopped out at a small loss, and they quickly place a new order in the direction of the breakout.” Fundamental of Technical Analysis and Algorithmic Trading 39 Some oscillators benefits of rectangles as well. They buy when the price fall to bottom line and when the price reaches to top line start to sell. To decrease the investment risks if the price exit from rectangle pattern, such people spot a lower price less than bottom line price as “Stop-loss” for themselves. ( i.e.: if 10% less than their bid price, so at most they will loss 10% ) Fundamental of Technical Analysis and Algorithmic Trading 40 Fundamental of Technical Analysis and Algorithmic Trading 41 These formations are similar to the H&S formations, but there is no head. These are reversal patterns with the same measuring implications as the H&S. It happens rarely. Fundamental of Technical Analysis and Algorithmic Trading 42 Fundamental of Technical Analysis and Algorithmic Trading 43 Fundamental of Technical Analysis and Algorithmic Trading 44 Typical Price Action On a chart, a double top looks like the letter M. It forms when prices advance to a certain level, turn down, rise again to near the previous peak, and then move down a second time to below the valley between the two peaks. The double bottom, which looks like the letter W, is the same as the double top except upside down. Triple tops and bottoms make three tops and bottoms instead of two. Frequency of Occurrence : True double tops and double bottoms are rare; triple tops and triple bottoms are even rarer. Fundamental of Technical Analysis and Algorithmic Trading 45 Typical Volume Action For a double top, Volume on the rise to the second peak is lower than on the first peak. - If volume is relatively higher, chances of a double top occurring are reduced. For a double bottom, volume shows a marked increase on the rally from the second bottom. For triple tops, volume is relatively less on the second advance than the first and even less on the third advance. For triple bottoms, volume is relatively higher on the second rally than the first and still greater on the third advance. Triple Top: at up warding side, V1>V2 >V3 Triple bottom: at up warding side, V3>V2>V1 Fundamental of Technical Analysis and Algorithmic Trading 46 One must wait for confirmation of the pattern, which does not occur until the price goes below the low price of the valley between the two peaks (or above the high price of the peak between two valleys for double bottoms). A further test of validity is the time element. Peaks should be separated by a significant reaction. If the two tops (peaks) are near each other, they could very well be part of a consolidation area. As a yardstick, use the criteria of peaks being one month apart and the valley being at least 15 percent lower than the top peak price. True double and triple tops and bottoms do have measuring implications. Expect prices to move in the direction of the reversal at least the distance from the valley to the peak. Fundamental of Technical Analysis and Algorithmic Trading 47 Fundamental of Technical Analysis and Algorithmic Trading 48 Fundamental of Technical Analysis and Algorithmic Trading 49 First and second peaks are perfect point to place sell orders. After the double top has been confirmed and if prices are moving up again with low volume, it is an opportune point to sell. One can sell short with a stop (calculated loss) above the highest peak of the Double top. The next opportune point to sell would be after a Triple top has formed and a fourth top is being formed at the lower level. The formation of Triple bottom occurs during the period of accumulation. Fundamental of Technical Analysis and Algorithmic Trading 50