Dominate the Markets with Smart Technical Analysis-TA 101 – Part 12
Volume Confirmation of Price Patterns
When identifying potential price patterns on a chart, it is crucial to try and verify that the market psychology behind the price pattern is really happening at that point on the chart. One of the best ways to do that is to use volume to confirm things.
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When a rectangle pattern is used, the volume should be decreasing as the rectangle forms. Volume should generally decline as a rectangle pattern develops, though there may be surges in volume anytime prices approach the top or bottom of the pattern. As soon as the breakout occurs, volume is likely to increase significantly as people become aware that the support or resistance line has been broken.
Triangle patterns should have a similar volume pattern – decreasing volume while the triangle is forming with a sharp increase in volume once a breakout is achieved.
Again, the diagrams above are idealized – the real-world is much messier. Consider this example:
Pay attention to the fact that EWG did not have a steady drop in volume; rather, it had a series of tiny spikes that changed the “coil’s” direction. However, the most important thing is that each mini-spike was smaller than the one before it (with the exception of October 30, which occurred early in the formation of the coil). Once that downward volume trend was well established, a big spike above that trend line would signal the breakout – just like on December 6.
Consolidation / Continuation Patterns vs. Reversal Patterns
So far, the two price patterns we’ve looked at – Rectangles and Triangles – are examples of Consolidation Patterns, also known as Continuation Patterns. They are referred to as such because, typically, prices will continue in the same trend they were in prior to the pattern’s formation. To put it another way, prices will typically resume their uptrend once the rectangle pattern ends if they were already in an uptrend before it formed. In essence, consolidation patterns are locations where bears and bulls engage in a second, albeit weak, short-term argument regarding the stock. The bigger picture doesn’t really change.
Next, we are going to start looking at Reversal Patterns. These are where the fireworks occur. Reversal patterns are the major conflicts, whereas consolidation patterns are merely skirmishes. When reversal patterns start to appear, the current trend is in real danger and lots of people start to pay attention.
In part 13 we’ll look at the granddaddy of all reversal patterns – the Head and Shoulders reversal.
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