CHAPTER3 PATTERN STUDY Learning Objectives After studying this chapter the student should be able to understand: + Formation of support and resistance lines + Change of support to resistance and vice versa + How to trade head and shoulders pattern * Volume study in head and shoulders pattern * Double top and double bottom + The gap analysis 3.1. What are support and resistance lines? Support and resistance represent key junctures where the forces of supply and demand meet. These lines appear as thresholds to price patterns. They are the respective lines which stops the prices from decreasing or increasing A support line refers to that level beyond which a stock's price will not fall. It denotes that price level at which there is a sufficient amount of demand to stop and possibly, for a time, turn a downtrend higher. Similarly a resistance line refers to that line beyond which a stock's price will not increase. It indicates that price level at which a sufficient supply of stock is available to stop and possibly, for a time, head off an uptrend in prices. Trend lines are often referred to as support and resistance lines on an angle. 3.1.1 Support A support is @ horizontal floor where interest in buying a commodity is strong enough to overcome the pressure to sell. Support level is the price level at which sufficient demand exists to, at least temporarily, halt a downward movement in prices. Logically as the price declines towards support and gets cheaper, buyers become more inclined to buy and sellers become less inclined to sell. By the time the price reaches the support level, it is believed that demand will overcome supply and prevent the price from falling below support 46SUPPORT LEVEL Support does not always hold true and a break below support signals that the bulls have lost over the bears. A fall below support level indicates more willingness to sell and a lack of wil ingness to buy. A break in the levels of support indicates that the expectations of sellers are reducing and they are ready to sell at even lower prices. In addition, buyers could not be coerced into buying until prices declined below support or below the previous low. Once support is broken, another support level will have to be established at a lower level \ : a la 1 I | “| i, iN z VW | 1 a” Ace supper sound 720 a bea i a Tear aera bate Neate Tae hes ee “| ACC chart showing the support level at 720 473.1.2 Resistance A resistance is a horizontal ceiling where the pressure to sell is greater than the pressure to buy. Thus a Resistance level is a price at which sufficient supply exists to; at least temporarily, halt an upward movement. Logically as the price advances towards resistance, sellers become more inclined to sell and buyers become less inclined to buy, By the time the price reaches the resistance level, it is believed that supply will overcome demand and prevent the price from rising above resistance. RESISTANCE LEVEL Resistance does not always hold true and a break above resistance signals that the bears have lost over the bulls. A break in the resistance level shows more willingness to buy or lack of incentive to sell. Resistance breaks and new highs indicate that buyer's expectations have increased and are ready to buy at even higher prices. In addition, sellers could not be coerced into selling until prices rose above resistance or above the previous high. Once resistance is broken, another resistance level will have to be established at a higher level. 48FESISTANCE AT 15595 ] Ij" ELRODOLLAR ageaes RESISTANCE AROUND 1.4990 A EEE es Euro showing resistance around 1.4930 and then 1.5896 3.1.3. Why do support and resistance lines occur? A stock's price is determined by supply and demand. Bulls buy when the stock’s is prices are too low and bears sell when the price reaches its maximum. Bulls increase the prices by increasing the demand and bears decrease it by increasing the supply. The market reaches a balance when bulls and bears agree on a price. When prices are increasing upward, there exists a point at which the bears become more aggressive the bulls begin to pull back - the market balances along the resistance line. When prices are going downwards, the market balances along the support line. As prices starts to decline toward the support line, buyers become more inclined to buy and sellers start holding on to their stocks. The support line marks the point where demand takes precedence over supply and prices will not decrease below that support line. The reverse holds true for a resistance line. Prices often break through support and resistance lines. A break through a resistance line shows that the buyers have won out over the sellers. The price of the stock is bid higher than the previous levels by the Bulls. Once the resistance line is broken, another will be created at a higher level. The reverse holds true for a support line. 3.1.4 Support and resistance zones Support and resistance is often thought of as a price level. For example, analysts and traders might discuss support for Nifty futures contract is at 4850. As a trader, if you are looking for 49a place to go long would you wait for the market to actually trade at 4850 before taking a position? Should you buy one, two or maybe five ticks above the low and stop yourself out one tick through the low to manage your risk in the long position. If you wait for a test of support, you could miss a trading opportunity. The problem is thinking about support and resistance as a precise price level and this is where most traders err. It is very common for most people to think of support and resistance levels in terms of absolute price levels. For instance, if they are looking at Rs 50 as a resistance levels, they mean exactly Rs 50 In reality, support and resistance levels are not exact prices, but rather price zones. So, if the resistance level is Rs5O, then it is actually the zone around that 50 level that is the resistance. The stock may hit only 49.87 or it may hit 50.25 and still hold the Rs 50 as price resistance. One solution is to use price zones for support and resistance instead of price levels. Support and resistance zones give you a better trading opportunity. A risk taking investor may buy at top of support zone whereas a cautious investor may want to wait till the bottom of support zone. ~ SUPPORT ZONES: The main factor in determining exactly how much the exact prices are tested by is how quickly or slowly the prices move into that resistance zone. For instance, if the zone hits very quickly on a large momentum surge, then it is more likely to hit that 50.25 level. This is also the case if the stock is a rather volatile one with a wide price range intraday. If the security spikes higher and does not quite hit the price resistance, such as a spike into 49.70, then it may round off into 50 with slightly higher highs and never exactly touch the Rs 50 price resistance zone before turning over due to the slowdown in momentum into that resistance. The larger the time frame, the greater the price zone is as well. A resistance zone at 50 on a weekly time frame may have a range of 1 Rs on each side of 50. Where traders tend to run into trouble 50is in thinking that because the stock has traded over 50 therefore the Rs 50 resistance has been broken, so we often hear of people “buying the highs” or “shorting the lows” in the case of support. Resistance levels can transform into support levels and vice versa. After prices break through a support level, investors may try to limit their losses by selling the stock, pushing prices back up to the line which now becomes a resistance level 3.1.5. Change of support to resistance and vice versa Another principle of technical analysis stipulates that support can turn into resistance and visa versa. Once the price penetrates below the support level, the earlier or the broken support level can turn into resistance, The break of support level signals that the forces of supply have overcome the forces of demand. Therefore, if the price returns to this level, there is likely to be an increase in supply, and hence resistance WIPRO (DAILY) CHANGE OF SUPPORT TO RESISTANCE AROUND 440 | ill i hut { A I hy q Wipro chart showing change of support around 440 to resistance Another aspect of technical analysis is resistance turning into support. As the price increases above resistance, it signals changes in demand and supply. The breakout above resistance proves that the forces of demand have overcome the forces of supply. If the price returns to this level, there is likely to be an increase in demand and support can be established at this point 51eee eee ee i! Fit fr : 7 | I I ! EE Ee ee Crude oil chart showing change of resistance to support around 100$ 3.1.6 Why are support and resistance lines important? Technical analysts often say that the market has a memory. Support and resistance lines are a key component of that memory. Investors “tend” to remember previous area levels and thus make them important. When a price of a stock is changing rapidly each day the buying and selling will be done at a divergent level and there will not exist any unanimity or pattern in price changing. But when prices trade within a narrow range for a period of time an area is formed and investors begin to remember that specific price. If the prices stay in an area for a longer period than the volume of that spot increases and that level becomes more important because investors remember it exceptionally well. Therefore, that level becomes more significant for the technical analyst. According to experts, previous support and resistance levels can be used as “target” or “limit” prices when the market have traded away from them. Assume that a year ago a rally ended with a top price of 120. That price of 120 then becomes a resistance level for the rally occurring in today's market. 3.2 Head and Shoulders The head and shoulders pattern can be either head and shoulders, top or head and shoulders bottom. The Charts are a picture of a head and shoulders movement, which portrays three successive rallies and reactions with the second one making the highest/lowest point. 523.2.1 Head and Shoulders (Top reversal) A Head and Shoulders (Top) is a reversal pattern which occurs following an extended uptrend forms and its completion marks a trend reversal. The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected to form support, or a neckline Right Shoulder Left Shoulder Sell point Bearish Head and Shoulders pattern as a reversal signal in an up-trend. Head & Shoulders Right Shoulder I ea oo We ysisom I maton in cA wa le: Domard Sep Conan Le iy ‘iy aseeneriacle Seca , Baten tr Une Sonne Came ny \ As its name implies, the head and shoulders reversal pattern is made up of a left shoulder, head, right shoulder, and neckline. Other parts playing a role in the pattern are volume, the 53breakout, price target and support turned resistance. Lets look at each part individually, and then put them together with some example 1. Prior trend: It is important to establish the existence of a prior uptrend for this to be a reversal pattern. Without a prior uptrend to reverse, there cannot be a head and shoulders reversal pattern, or any reversal pattern for that matter. 2. Left shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. It is formed usually at the end of an extensive advance during which volume is quite heavy. At the end of the left shoulder there is usually a dip or recession which typically occurs on low volume. 3. Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. At this point, in order conform to proper form, prices must come down somewhere near the low of the left shoulder ~somewhat lower perhaps or somewhat higher but in any case, below the top of the left shoulder. 4. Right shoulder: The right shoulder is formed when the low of the head advances again. The peak of the right shoulder is almost equal in height to that of the left shoulder but lower than the head. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline. 5. Neckline: A neckline can be drawn across the bottoms of the left shoulder, the head and the right shoulder. A breaking of this neckline on a decline from the right shoulder is the final confirmation and completes the head and shoulder formation. 6. Volume: As the head and shoulders pattern unfolds, volume plays an important role in confirmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing volume levels. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. These decreases in volume along with new highs that form the head serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final confirmation comes when volume further increases during the decline of the right shoulder. 7. Neckline break: The head and shoulders pattern is said to be complete only when the neckline support is broken. Ideally, this should also occur in a convincing manner with an expansion in volume. 8. Support turned resistance: Once support is broken, it is common for this same support level to turn into resistance, Sometimes, but certainly not always, the price will return to the support break, and offer a second chance to sell 9. Price target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. Price target is calculated by 54subtracting the above distance from the neckline. Any price target should serve as a rough guide, and other factors such as previous support levels should be considered as well. ea a owoneK no oanvinexossvouoen — FS \ : a 2 i 3 3 4 i 3 ) 4 ABHISHEK IND chart showing the Head and Shoulders pattern aaa See eee : I \ sus rompares | 4 ih iL » : hile yl ae vat 4 (ute | | i sal ‘br A c D ue In i wl i hi al ly n iL Potato futures (MCX) showing H&S Pattern 55Signals generated by head and shoulder pattern Left shoulder Right shoulder The support line is based on points B and C. © The resistance line. After giving in at point D, the market may retest the neckline at point E. ¢ The price direction. If the neckline holds the buying pressure at point €, then the formation provides information regarding the price direction: diametrically opposed to the direction of the head-and-shoulders (bearish). © The price target D to F. This is provided by the confirmation of the formation (by breaking through the neckline under heavy trading volume). This is equal to the range from top of the head to neckline. Volume study Price HT SHOULDER LEFT SHOULDER NECKLINE 56Some important points to remember + The head and shoulders pattern is one of the most common reversal formations. It occurs after an uptrend and usually marks a major trend reversal when complete. + It is preferable that the left and right shoulders be symmetrical, i is not an absolute requirement. They can be different widths as well as different heights. * Volume support and neckline support identification are considered to be the most critical factors. The support break indicates a new willingness to sell at lower prices. There is an increase in supply combined with lower prices and increasing volume .The combination can be lethal, and sometimes, there is no second chance return to the support break. + Measuring the expected length of the decline after the breakout can be helpful, but it is not always necessary target, As the pattern unfolds over time, other aspects of the technical picture are likely to take precedence. 3.2.2 Inverted head and shoulders The head and shoulders bottom is the inverse of the H&S Top. In the chart below, after a period, the downward trend reaches a climax, which is followed by a rally that tends to carry the share back approximately to the neckline. After a decline below the previous low followed by a rally, the head is formed. This is followed by the third decline which fails to reach the previous low. The advance from this point continues across the neckline and constitutes the breakthrough. INVERTED. HEAD AND SHOULDERS AS & REVERSAL PATTERN IN A DOWNTREND (BULLISH) 4 NEOKLINE ae Sa LEFT SHOULDER RIGHT SHOULDER 57Head & Shoulders Reversal bil \ | il i Confirmation Line Break A.Rising Confirmation Line is a Stronger Head & ‘Shoulders Reversal Patter than a Decreasing Confirmation Line "Yl | I \ vigt ‘Shoulder ‘Shoulder The main difference between this and the Head and Shoulders Top is in the volume pattern associated with the share price movements. The volume should increase with the increase in the price from the bottom of the head and then it should start increasing even more on the rally which is followed by the right shoulder. If the neckline is broken but volume is low, you should be skeptical about the validity of the formation. As a major reversal pattern, the head and shoulders bottom forms after a downtrend, and its completion marks a change in trend. The pattern contains three troughs in successive manner the two outside troughs namely the right and the shoulder being lower in height than the middle trough (head) which is the deepest. Ideally, the two shoulders i.e, the right and the left shoulder should be equal in height and width. The reaction highs in the middle of the pattern can be connected to form resistance, or a neckline. 3.2.3. Head and shoulders bottom The price action remains roughly the same for both the head and shoulders top and bottom, but in a reversed manner. The biggest difference between the two is played by the volume. While an increase in volume on the neckline breakout for a head and shoulders top is welcomed, it 58is absolutely required for a bottom. Lets look at each part of the pattern individually, keeping volume in mind 1. Prior trend: For this to be a reversal pattern it is important to establish the existence of a prior downtrend for this to be a reversal pattern. There cannot be a head and shoulders bottom formation, without a prior downtrend to reverse. 2. Left shoulder It is formed after an extensive increase in price, usually supported by high volume. While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the formation of the left shoulder. The high of the decline usually remains below any longer trend line, thus keeping the downtrend intact. 3. Head: After the formation of the left shoulder, a decline begins that exceeds the previous low and forms a point at an even lower point. After making a bottom, the high of the subsequent advance forms the second point of the neckline. 4. Right shoulder: Right shoulder is formed when the high of the head begins to decline. The height of the right shoulder is always less than the head and is usually in line with the left shoulder, though it can be narrower or wider. When the advance from the low of the right shoulder breaks the neckline, the head and shoulders reversal is complete. 5. Neckline: The neckline is drawn through the highest points of the two intervening troughs and may slope upward or downward. The neckline forms by connecting two reaction highs. The first reaction marks the end of the left shoulder and the beginning of the head. The second reaction marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two reaction highs, the neckline can slope up, slope down, or be horizontal. The slope of the neckline will affect the pattern’s degree of bullishness: an upward slope is more bullish than downward slope 6. Volume: Volume plays a very important role in head and shoulders bottom Without the proper expansion of volume, the validity of any breakout becomes suspect. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing the absolute levels associated with each peak and trough. Volume levels during the second half of the pattern are more important than the first half. The decline of the volume of the left shoulder is usually heavy and selling pressure is also very intense, The selling continues to be intense even during the decline that forms the low of the head. After this low, subsequent volume patterns should be watched carefully to look for expansion during the advances. The advance from the low of the head should be accompanied by an increase in volume and/or better indicator readings (e.g. CMF > 0 or strength in OBV). After the formation the 59second neckline point by the reaction high, there should be a decline in the right shoulder accompanied with light volume. It is normal to experience profit-taking after an advance. Volume analysis helps distinguish between normal profit-taking and heavy selling pressure. With light volume on the pullback, indicators like CMF and OBV should remain strong. The most important moment for volume occurs on the advance from the low of the right shoulder. For a breakout to be considered valid there needs to be an expansion of volume on the advance and during the breakout Right shoulder Time 1. Neckline break: The head and shoulders pattern is said to be complete only when neckline resistance is broken. For a head and shoulders bottom, this must occur in a convincing manner with an expansion of volume. 2, Resistance turned support: The same resistance level can turn into support, if the resistance is broken. Price will return to the resistance break and provide a second chance to buy. 3. Price target: Once the neckline resistance is broken, the projected advance is calculated by measuring the distance from the neckline to the bottom of the head. This distance is then added to the neckline to reach a price target. Any price target should serve as a rough guide and other factors should be considered as well. These factors might include previous resistance levels, Fibonacci retracements or long-term moving averages. 60(NI INDEX (INVERTED HEAD 8 SHOLLOERPATTERNY QUEROUEEEEOERRORCE ERRE ROR E ANE ARS ang CNX IT INDEX Chart Showing Inverse Head and Shoulders Pattern Once the neckline breaches the prices of index starts ri Neckline Right shoulder Left shoulder ~~ Once the resistance is broken at point D the price target will be equal to the bottom of the head from neckline, It may test the line again at point E therefore the stop should be below the neckline. 61Some important points to remember: * Head and shoulder bottom is one of the most common and reliable reversal formations. They occur after a downtrend and usually mark a major trend reversal when complete. + It is preferable but not a necessary requirement that the left and right shoulders be symmetrical. Shoulders can be of different widths as well as different heights. If you are looking for the perfect pattern, then it will take a long time to come. + The major focus of the analysis of the head and shoulders bottom should be the correct identification of neckline resistance and volume patterns. These are two of the most important aspects to a successful trade. The neckline resistance breakout combined with an increase in volume indicates an increase in demand at higher prices. Buyers are exerting greater force and the price is being affected, + As seen from the examples, traders do not always have to choose a stock after the neckline breakout. Many times, the price will return to this new support level and offer a second chance to buy. Measuring the expected length of the advance after the breakout can be helpful, but it is not always necessary to achieve the final target. As the pattern unfolds over time, other aspects of the technical picture are likely to take precedent. 3.3 Double tops and bottoms Double Top Double Bottom Previous 7 Downtrend Neck Line Bottom —_ Bottom Previous Uptrend ‘These are considered to be among the most familiar of all chart patterns and often signal turning points, or reversals. The double top resembles the letter "M”. Conversely, the double bottom resembles a “W" formation; in reverse of the double top. 623.3.1 Double top It is a term used in technical analysis to describe the rise of a stock, a drop and another rise roughly of the same level as the previous top and finally followed by another drop. A double top is a reversal pattern which occurs following an extended uptrend. This name is given to the pair of peaks which is formed when price is unable to reach a new high. It is desirable to sell when the price breaks below the reaction low that is formed between the two peaks. Context: The double top must be followed by an extended price rise or uptrend. The two peaks formed need not be equal in price, but should be same in the area with a minor reaction low between them. This is a reliable indicator of a potential reversal to the downside. Appearance: Price moves higher and forms a new high. This is followed by a downside retracement, which forms a reaction low before one final low-volume assault is made on the area of the recent high. In some cases the previous high is never reached, and sometimes it is briefly but does not hold. This pattern is said to be complete once price makes the second peak and then penetrates the lowest point between the highs, called the reaction low. The sell indication from this topping pattern occurs when price breaks the reaction low to the downside. Breakout expectation: When the reaction low is penetrated to the downside, accompanied by expanding volume the double top pattern becomes official. Downside price target is calculated by subtracting the distance from the reaction low to the peak from the reaction low. Often times a double top will mark a lasting top and lead to a significant decline which exceeds the price target to the downside. Although there can be variations but if the trend is from bullish to bearish, the classic double top will mark at least an intermediate change, if not long-term change. Many potential double tops can form along the way up, but until key support is broken, a reversal cannot be confirmed. Let’s look at the key points in the formation: 63Double Top Top Neck Line { Price breaks the neck line and continues: to move down 1 Prior trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the double top, a significant uptrend of several months should be in place. 2. First peak: The first peak marks the highest point of the current trend. 3, Trough: Once the first peak is reached, a decline takes place that typically ranges from 10-20%. The lows are sometimes rounded or drawn out a bit, which can be a sign of tepid demand 4. Second peak: The advance off the lows usually occurs with low volume and meets resistance from the previous high. Resistance from the previous high should be expected and after the resistance is met, only the possibility of a double top exists, The pattern still needs to be confirmed. The time period between peaks can vary from a few weeks to many months, with the norm being 1-3 months. While exact peaks are preferable, there is some leeway. Usually a peak within 3% of the previous high is adequate. 5. Decline from peak: Decline in the second peak is witnessed by an expanding volume and/or an accelerated descent, perhaps marked with a gap or two. Such a decline shows that the forces of supply are stronger than the forces of demand and a support test is imminent. 6. Support break: The double top and trend reversal are not complete even when the trading till the support is done. The double top pattern is said to be complete when the support breaks from the lowest point between the peaks. This too should occur with an increase in volume and/or an accelerated descent. 647. Support turned resistance: Broken support becomes potential resistance and there is sometimes a test of this newfound resistance level with a reaction rally 8. Price target: Price target is calculated by subtracting the distance from the support break to peak from the support break. The larger the potential decline the bigger will be the formation. ALEMBIC LTD Chart Showing Double Top BHEL (DAILY) DOUBLE TOP E EH pee verre fi Il vl lull wall HN tl fi han al | ld BHEL Chart showing Double Top : + This stock formed a double top after a big price advance. But it fails to breach the resistance and results in price falls. Points to be kept in mind: + Technicians should take proper steps to avoid deceptive double tops. The peaks should be separated by a time period of at least a month. If the peaks are too close, they could just represent normal resistance rather than a lasting change in the supply/demand picture, Ensure that the low between the peaks declines at least 10%. Declines less than 10% may not be indicative of a significant increase in selling pressure. After the decline, analyze the trough for clues on the strength of demand. If the trough drags on a bit and has trouble moving back up, demand could be drying up. When the security does advance, look for a contraction in volume as a furthe! \dication of weakening demand. * The most important aspect of a double top is to avoid jumping the gun. The support should be broken in a convincing manner and with an expansion of volume. A price or time filter 65can be applied to differentiate between valid and false support breaks. A price filter might require a 3% support break before validation. A time filter might require the support break to hold for 3 days before considering it valid. The trend is in force until proven otherwise. This applies to the double top as well. Until support is broken in a convincing manner, the trend remains up. 3.3.2 Double bottom Double bottom is a charting technique used in technical analysis. It is used to describe a drop in the value of a stock (index), bounces back and then another drop to the similar level as the previous low and finally rebounds again. A double bottom is a reversal pattern which occurs following an extended downtrend. The buy signal is when price breaks above the reaction high which is formed between the two lows. Context: The double bottom must be followed by an extended decline in prices. The two lows formed have to be equal in areas with a minor reaction high between them, though they need not to be equal in price. This is a reliable indicator of a potential reversal to the upside. Appearance: Price reduces further to form a new low. This is followed by upside retracement or minor bounce, which forms a reaction high before one final low-volume downward push is made to the area of the recent low. In some cases the previous low is never reached, while in others it is briefly penetrated to the downside, but price does not remain below it, This pattern is considered complete once price makes the second low and then penetrates the highest point between the lows, called the reaction high. The buy indication from this bottom pattern occurs when price breaks the reaction high to the upside. Breakout expectation: A double bottom pattern becomes official when the reaction high is penetrated to the upside, ideally accompanied by expanding volume. Upside price target is calculated adding the distance from the reaction high to the low to that of reaction high. Often times a double bottom will mark a lasting low and lead to a significant price advance which exceeds the price target to the upside. ‘There can be many variations that can occur in the double bottom, but the classic double bottom usually marks an intermediate or a long-term change in trend. Many potential double bottoms can be formed along the way down, but a reversal cannot be confirmed until key resistance is broken. The key points in the formation are as follows: 66the neck line and continues to move up. ~ ell? Price breaks I 0 i 4 Neck Line tt ys i gil Bottom Bottom 1. Prior trend: With any reversal pattern, there must be an existing trend to reverse. In the case of the double bottom, a significant downtrend of several months should be in place. 2. First trough: It marks the lowest point of the current trend, Though it is fairly normal in appearance and the downtrend remains firmly in place. 3. Peak: After the first trough is reached, an advance ranging from 10-20% usually takes place. An increase in the volume from the first trough signals an early accumulation. The peaks high is sometimes rounded or drawn out a bit because of the hesitation in going back. This hesitation is an indication of an increase in demand, but this increase is not strong enough for a breakout. 4. Second trough: The decline off the reaction high usually occurs with low volume and meets support from the previous low. Support from the previous low should be expected. Even after establishing support, only the possibility of a double bottom exists, it still needs to be confirmed. The time period between troughs can vary from a few weeks to many months, with the norm being 1-3 months. While exact troughs are preferable, there is some room to maneuver and usually a trough within 3% of the previous is considered valid. 5. Advance from trough: Volume gains more importance in the double bottom than in the double top. The advance of the second trough should be clearly evidenced by the increasing volume and buying pressure. An accelerated ascent, perhaps marked with a gap or two, also indicates a potential change in sentiment. 676. Resistance break: The double top and trend reversal are considered incomplete, even after they trade up to resistance. Breaking resistance from the highest point between the troughs completes the double bottom. This too should occur with an increase in volume and/ or an accelerated ascent. 7. Resistance turned support: Broken resistance becomes potential support and there is sometimes a test of this newfound support level with the first correction. Such a test can offer a second chance to close a short position or initiate a long 8. Price target: Target is estimated by adding the distance from the resistance breakout to trough lows on top of the resistance break. This would imply that the bigger the formation is, the larger the potential advance. t (CRUDE OIL (NYMEX) DOUBLE BOTTOM H a See ee Eee eS z fer Crude oil chart showing Double Bottom Points to be kept In Mind * The double bottom is an intermediate to long-term reversal pattern that will not form in a few days. Though it can be formed in a time span of few weeks, but it is preferable to have at least a time of 4 weeks between the two lows. Bottoms usually take more time than the top, This pattern should be given proper time to develop. * The advance off of the first trough should be 10-20%. The second trough should form a low within 3% of the previous low and volume on the ensuing advance should increase. Signs of buying pressure can be checked by the volume indicators such 68as Chaikin Money Flow, OBV and Accumulation/Distribution. The formation is not complete until the previous reaction high is taken out. 3.3.3 Rounded top and bottom ROUNDED TOP ROUNDED BOTTOM Another shape which a top and bottom can take is one in which the reversal is *rounded” The rounded bottom formation forms when the market gradually yet steadily shifts from a bearish to bullish outlook while in the case of a rounded top, from bullish to bearish. The Rounded Top formation consists of a gradual change in trend from up to down. The Rounded Bottom formation consists of a gradual change in trend from down to up. This formation is the exact opposite of a Rounded Top Formation. The prices take on a bow! shaped pattern as the market slowly and casually changes from an upward to a downward trend he F vl Hy ROUNDED TOP FORHIATION It | : | fy ni ih I hy bod \ y uly, bias of ih il il I ya lag ioyuall a | OMAXE Chart showing Rounded Top 69It is very (remove) considered very difficult to separate a rounded bottom, where the price continues to decrease from a consolidation pattern and where price stays at a level, but the clue, as always, is in volume. In a true Rounded Bottom, the volume decreases as the PI can be seen when the price movement becomes neutral and goes sideways and the volumes e decreases, this signifies a decrease in the selling pressure. A very little trading activity are also low. Then, as prices start to increase, the volume increases. Share Price Xe Wall. A gap is an area on a price chart in which there were no trades. Normally this occurs after the Price 3.4 Gap theory close of the market on one day and the next day's open. Lot's of things can cause this, such as an earnings report coming out after the stock market had closed for the day. If the earnings were significantly higher than expected, this could result in the price opening higher than the previous day's close. If the trading that day continues to trade above that point, a gap will exist in the price chart, Gaps can offer evidence that something important has happened to the fundamentals or the psychology of the crowd that accompanies this market movement. Gaps appear more frequently on daily charts, where every day is an opportunity to create an opening gap. Gaps can be subdivided into four basic categories: * Common gap + Breakaway gap + Runaway/ Continuation gap + Exhaustion gap 703.4.1 Common gaps Common Gaps NO STRONG TREND AND THE GAP IS FILLED SOON ‘Sometimes referred to as a trading gap or an area gap, the common gap is usually uneventful. This gap occurs characteristically in nervous markets and is generally closed within few days. In fact, they can be caused by a stock going ex-dividend when the trading volume is low. Getting closed means that the price action at a later time (few days to a few weeks) usually retraces to at the least the last day before the gap. This is also known as filling the gap. A common gap usually appears in a trading range or congestion area and reinforces the apparent lack of interest in the stock at that time, Many times this is further exacerbated by low trading volume. Being aware of these types of gaps is good, but doubtful that they will produce trading opportunities. 3.4.2 Breakaway gaps BREAKAWAY GAPS NEWHIGHS | | a im Tyo UPSIDE BREAKOUT DOWNSIDE BREAKOUT. FROM RANGE FROM RANGE 71Breakaway gaps are the exciting ones. They occur when the price action is breaking out of their trading range or congestion area, To understand gaps, one has to understand the nature of congestion areas in the market. A congestion area is just a price range in which the market has traded for some period of time, usually a few weeks or so. The area near the top of the congestion area is usually resistance when approached from below. Likewise, the area near the bottom of the congestion area is support when approached from above. To break out of these areas requires market enthusiasm and either many more buyers than sellers for upside breakouts or more sellers than buyers for downside breakouts. Volume will (should) pick up significantly, for not only the increased enthusiasm, but many are holding positions on the wrong side of the breakout and need to cover or sell them. It is better if the volume does not happen until the gap occurs. This means that the new change in market direction has a chance of continuing, The point of breakout now becomes the new support (if an upside breakout) or resistance (if a downside breakout). Don't fall into the trap of thinking this type of gap, if associated with good volume, will be filled soon. It might take a long time. Go with the fact that a new trend in the direction of the stock has taken place and trade accordingly. A good confirmation for trading gaps is if they are associated with classic chart patterns. For example, if an ascending triangle all of a sudden has a breakout gap to the upside, this can be a much better trade than a breakaway gap without a good chart pattern associated with it. 3.4.3. Runaway gaps tal RUNAWAYICONTINJATION GAP II fl ta A i crane 100) fn is |S hy fae} iz el bad i fon 72Runaway gaps are also called measuring gaps and are best described as gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the up trend and while waiting for a retracement in price, decided it was not going to happen. Increased buying interest happens all of a sudden and the price gaps above the previous day’s close. This type of runaway gap represents an almost panic state in traders. Also, a good uptrend can have runaway gaps caused by significant news events that cause new interest in the stock Runaway gaps can also happen in down trends. This usually represents increased liquidation of that stock by traders and buyers who are standing on the sidelines. These can become very serious as those who are holding onto the stock will eventually panic and sell, but sell to whom? The price has to continue to drop and gap down to find buyers. Not a good situation. The futures market at times will have runaway gaps that are caused by trading limits imposed by the exchanges. Getting caught on the wrong side of the trend when you have these limit moves in futures can be horrifying. The good news is that you can also be on the right side of them, These are not common occurrences in the futures market despite all the wrong information being touted by those who do not understand it and are only repeating something they read from an uninformed reporter. 3.4.4 Exhaustion gaps 7 \ EXGAUETION GAP JEERA en) ] Exhaustion gaps are those that happen near the end of a good up or down trend, They are many times the first signal of the end of that move. They are identified by high volume and 73large price difference between the previous day’s close and the new opening price. They can easily be mistaken for runaway gaps if one does not notice the exceptionally high volume. It is almost a state of panic if during a long down move pessimism has set in. Selling all positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly filled as prices reverse their trend. Likewise if they happen during a bull move, some bullish euphoria overcomes trades and they cannot get enough of that stock. The prices gap up with huge volume, then there is great profit taking and the demand for the stock totally dries up. Prices drop and a significant change in trend occurs. Exhaustion gaps are probably the easiest to trade and profit from. In the chart, notice that there was one more day of trading to the upside before the stock plunged. The high volume was the giveaway that this was going to be either an exhaustion gap or a runaway gap. Because of the size of the gap and an almost doubling of volume, an exhaustion gap was in the making here. 3.4.5 Island cluster in 2 pl isan et UsTeR z hy al | ~ hy Z Hy “ nyuyuigllial lyri YU ly poet Island clusters are identified by an exhaustion gap followed by a breakaway gap in opposite direction. They are powerful reversal signals Conclusion ‘There is an old saying that the market abhors a vacuum and all gaps will eventually be filled. While this may have some merit for common and exhaustion gaps, holding positions waiting for breakout or runaway gaps to be filled can be devastating to your portfolio. Likewise if 74waiting to get on board a trend by waiting for prices to fill a gap just might mean you never participate in the move. Gaps are a significant technical development in price action and in chart analysis, and should not be ignored. Japanese candlestick analysis is filled with patterns that rely on gaps to fulfill their objectives. New terms Breakout: A price movement through an identified level of support or resistance, which is usually followed by heavy volume and increased volatility, is a ‘breakout’, Traders will buy the underlying asset when the price breaks above a level of resistance and sell when it breaks below support. A breakout is the bullish counterpart to a breakdown. Climax: Following a protracted period of selling or buying, a point wherein market trends are retarded or discontinued. At a selling climax, the market is characterized by a trend reversal whereby the market be: occurs, and the market begins to sell, resulting in lower prices. The climax is merely the highest point of selling or buying and can be followed by many trend reversals \s to buy stocks and prices rise, For a buying climax, the opposite Distribution: Distribution is when trading volume is higher than that of the previous day without any price appreciation. Double Top: A term used in technical analysis to describe the rise of a stock, a drop, another rise to the same level as the original rise, and finally another drop. Double Bottom: A charting pattern used in technical analysis. It describes the drop of a stock (or index), a rebound, another drop to the same (or similar) level as the original drop, and finally another rebound. Downtrend: A Downtrend describes the price movement of a financial asset when the overall direction is downward. A formal downtrend occurs when each successive peak and trough is lower than the ones found earlier in the trend, Exhaustion ituation in which a majority of participants trading in the same asset are either long or short, leaving few investors to take the other side of the transaction when participants wish to close their positions. Exhaustion signals the reversal of the current trend because it illustrates excess levels of supply or demand Long: The buying of a security such as a stock, commodity, or currency, with the expectation that the asset will rise in value is called ‘Long’. Overbought: An asset that has experienced sharp upward movements over a very short period of time is often deemed to be overbought. Determining the degree in which an asset is overbought is very subjective and can differ between investors. 75Oversold: Assets that have experienced sharp declines over a brief period of time are often deemed to be oversold. Determining the degree to which an asset is oversold is very subjective and could easily differ between investors. Peak: The highest point between the end of an economic expansion and the start of a contraction in a business cycle indicates the ‘Peak’. The peak of the cycle refers to the last month before several key economic indicators, such as employment and new housing starts, begin to fall. It is at this point that real GDP spending in an economy is its highest level Recession: A significant decline in activity spread across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale- retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country’s gross domestic product (GDP). Recession is a normal (albeit unpleasant) part of the business cycle. A recession generally lasts from six to 18 months. Interest rates usually fall in recessionary times to stimulate the economy by offering cheap rates at which to borrow money. Resistance: The price at which a stock or market can trade, but not exceed, for a certain period of time. This is often referred to as “resistance level”. The stock or market stops rising because sellers start to outnumber buyers. Support: ‘Support’ is the price level which historically, a stock has had difficulty falling below. It is thought of as the level at which a lot of buyers tend to enter the stock. Trough: The stage of the economy’s business cycle that marks the end of a period of declining business activity and the transition to expansion is the Trough. 76Model Question Qi Q2 Q@3 Cr Qs 6 What does a decline below support level indicate? a) there is lack of sellers b) buyers are pushing down the price ©) there is lack of buyers and sellers are willing to sell even at lower prices d) none of the above Bulls bid __ the price by increasing demand, bears take it __by increasing supply a) down, up b) up, down ©) up, up d) down, down In Head & Shoulders pattern, which level is achieved by the second rally? a) Highest point b) Lowest point ©) _ Either highest or lowest point d) Neither highest nor lowest point In top reversal head and shoulders pattern, the decline from peak of should break the neckline. a) left shoulder b) right shoulder ©) head d) neckline In an inverted head and shoulders pattern, which of the following represent highest potential for trend reversal? a) upward sloping neckline b) downward sloping neckline ©) horizontal neckline d) vertical neckline A break down the support line shows that the have won out —_over the a) bulls; bears b) bears; bulls 77Q7_Inan uptrend, pattern is identified when the price of an asset creates three peaks, and all the three peaks are of nearly the —_ same level, at the same price level. a) Double Bottom b) Double Top ©) Triple Bottom d) Triple Top Q8 Double top is the name given to a pair of peak which is formed when price is unable to reach a a) New high b) New Low c) Any of the above d) None of the above Q9. Which gaps are also known as measuring gaps ? a) Common gaps b) Breakaway gaps c) Runaway gaps d) Exhaustion gaps Q10 The Rounded Top formation consists of a gradual change in trend from: a) Down to up b) Up to Down c) Up to Up d) Down to Down 78