The Essentials of Technical Analysis: Part III

When looking for patterns, it’s important to keep in mind that they’re more of an art than science. Pattern interpretations should be fairly specific, but not overly exacting as to obstruct the spirit of the pattern. A pattern may not fit the exact description, but that should not distract from its robustness. Below are patterns which I have found to be particularly useful and enriching in my personal experience as a professional trader.

A. Bump and Run Reversal: This pattern was developed by Thomas Bulkowski, and introduced in the June-97 issue of Technical Analysis of Stocks and Commodities. As the name implies, the Bump and Run Reversal (BARR) is a reversal pattern that forms after excessive speculation drives up too far, too fast. The pattern can be applied to daily, weekly, and monthly charts.

Bulkowski identified three phases to the pattern: lead-in, bump, and run. The lead-in phase can last 1 to 3 months and forms the basis from which to draw the trendline. During this phase, prices advance in an orderly manner and there is no excess speculation. The trendline should be moderately steep. If it is too steep, then the ensuing bump is unlikely to be significant enough. Bulkowski advises that an angle of 30 to 45 degrees is preferable. As the stock advances during the lead-in phase, volume is usually average and low. When the speculative advance begins to form the left side of the bump, volume expands as the advance accelerates. The bump phase forms with a sharp advance, and prices move further away from the lead-in trendline. Ideally, the angle of the trendline from the bump’s advance should be about 50% greater than the angle of the trendline extending up from the lead-in phase. Roughly speaking, this would call for an angle between 45 and 60 degrees. The distance from highest high of the bump to the lead-in trendline should be at least twice the distance from the highest high in the lead-in phase to the lead-in trendline. These distances can be measured by drawing a vertical line from the highest highs to the lead-in trendline. The run phase begins when the pattern breaks support from the lead-in trendline. Prices will sometimes hesitate or bounce off the trendline before breaking through. Once the break occurs, the run phase takes over and the declines continue.

B. Top Head and Shoulders Reversal: This 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 neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the beginning of the right shoulder. The slope of the neckline will affect the pattern’s degree of bearishness. A downward slope is more bearish than an upward slope. Sometimes more than one low point can be used to form a neckline. It is important to establish the existence of a prior uptrend for this to be a reversal pattern. While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder. The low of the decline usually remains above the trendline, keeping the uptrend intact. From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline. The advance from the low of the head forms the right shoulder. This peak is lower than the head, and usually in line with the high of the left shoulder. The head and shoulder pattern is not complete and uptrend is not reversed until neckline support.

C. Bottom Head and Shoulder Reversal: The pattern contains three successive troughs with the middle trough (head) being the deepest and the two outside troughs (shoulders) being shallower. Ideally, the two shoulders would be equal in height and width. The reaction highs in the middle of the pattern can be connected to form a neckline. After breaking the neckline resistance, the projected advance is found by measuring the distance from the neckline to reach a price target.

D. Double Top Reversal: The pattern is made up to two consecutive peaks that are roughly equal, with a moderate trough in between. 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 established. The first peak should mark the highest point of the current trend. After the first peak, a decline takes place that typically ranges from 10% to 20%. Volume on the decline from the first peak is usually inconsequential. The advance off the lows usually occurs with low volume and meets resistance from the previous high. 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. The subsequent decline from the second peak should witness an expansion in volume and/or an accelerated descent, perhaps marked with a gap or two. Such a decline show that the forces of demand are weaker than supply and that a support test is imminent. Breaking support from the lowest point between the peaks completes the double top.

E. Cup With Handle: The pattern was developed by William O’Neil and introduced in his 1988 book, “How to Make Money in Stocks”. There are two parts to the pattern: the cup and the handle. The cup forms after an advance and looks like a bowl or rounding bottom. As the cup is completed, a trading range develops on the right hand side, and the handle is formed. A prior trend should exist. Ideally, the trend should be a few months old and not too mature.

The more mature the trend, the less chance that the pattern marks a continuation or the less upside potential. The cup should be “U” shaped and resemble a bowl or rounding bottom. A “V” shaped bottom would be considered too sharp of a reversal to qualify. The softer “U” shape ensures that the cup is a consolidation pattern with valid support at the bottom of the “U”. Ideally, the depth of the cup should retrace 1/3 or less of the previous advance. However, with volatile markets and over-reactions, the maximum retracement could be 2/3. After the high forms on the right side of the cup, there is a pullback that forms the handle. Sometimes this handle resembles a flag or pennant that slopes downward, other times just a short pullback. The handle represents the final consolidation/pullback before the big breakout and can retrace up to 1/3 of the cup’s advance, but usually not more. The smaller the retracement is, the more bullish the formation and significant the breakout. Sometimes it is prudent to wait for a break above the resistance line established by the highs of the cup. The cup can extend 1 to 6 months, sometimes longer on weekly charts. The handle can be from 1 to many weeks, and ideally completes within 1 to 4 weeks.

F. Ascending Triangle: The ascending triangle is a bullish formation that usually forms during an up trend as a continuation pattern. Because of its shape, the pattern can also be referred to as a right-angle triangle. Two or more equal highs form a horizontal line at the top.

Two or more rising troughs form an ascending trendline that converges on the horizontal line as it rises. At least two reaction highs are required to form the top horizontal line. The highs do not have to be exact, but should be within reasonable proximity of each other. There should be some distance between the highs, and a reaction low between them. At least two reaction lows are required to form the lower ascending trendline. These reaction lows should be successfully higher and there should be some distance between the lows. If a more recent reaction low is equal to or less than the previous reaction low, then the ascending triangle is not valid.

Final thoughts:

While technical analysis can be a great help in trading the market, no technical indicator is infallible. Further, technical analysis is only as good as its interpreter. Finally, a significant of time must be spent in learning the principles of technical analysis, and in how to properly interpret the various charts and other technical indicators.In practice, many market players use technical analysis in conjunction with fundamental analysis to determine their strategy. One major advantage of technical analysis is that experienced analysts can follow many markets and market instruments, whereas the fundamental analyst needs to know a particular market intimately.

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