Dominate the Markets with Smart Technical Analysis-TA 101TA 101 – Part 11
Markets with Smart Technical Analysis Price Patterns
When the market does not agree on a stock’s value, price patterns occur. Essentially, they are the visual remains of a big battle between bulls and bears. They are similar to the nightly newscast weather patterns in many ways. Typically, the weather of today can be predicted by looking at atmospheric data from yesterday, but occasionally (frequently?) The prediction is incorrect. Similarly, chart patterns often but not always indicate future price movements.
At their core, most price patterns are combinations of several trend lines. The rectangle pattern is the simplest. Price moves between two horizontal lines of support and resistance in a rectangle pattern. Both the support and resistance lines must be touched at least twice for the pattern to be considered a rectangle. Rectangle patterns have a narrow or wide price range and last from days to months. When the support or resistance line is broken, the pattern ends.
A price break through resistance may be anticipated if volume expands when prices rise and contracts when prices fall within the rectangle pattern. An imminent price break above resistance may exist if prices don’t fall to the support line before rising again.
If volume within the rectangle pattern expands when prices fall and contracts when prices rise, a price break through support may be anticipated. If prices do not rise to the resistance line before falling again, there may be an imminent price break below support. The top (or bottom) of the rectangle transforms into a support or resistance line for the stock as shown above as soon as the pattern breaks down. The battle between bulls and bears is clearly depicted by rectangle patterns, with bulls consistently purchasing when prices reach a support level and bears consistently selling when prices reach a resistance level. Prices will break out of the pattern when one of those groups prevails. The breakout move will be larger and the new support/resistance line will be more significant the longer prices have been in the pattern. The Triangle Pattern is yet another prevalent price pattern. The triangle pattern is very similar to the rectangle, with the exception that the pattern’s upper and/or lower trend lines are sloped rather than horizontal. Go back to the rectangle diagram above and imagine that bearish sentiment about the stock was growing over time. How would that appear? In that case, more and more sellers would sell immediately rather than wait for prices to return to the level of the red resistance line. They would, instead, sell earlier. That would transform the red resistance line into a trend line that goes down, resulting in a Descending Triangle Pattern.
Alternately, what if buyers started getting impatient and started buying before the stock got back to its green support line? Then a Rising Triangle Pattern would form.
And what if both the bulls became more bullish while at the same time, the bears became more bearish? Then both the red and green lines would be slanted and we’d have a Symmetric Triangle Pattern.
By the way, triangle patterns are also referred to as “coils.” Can you see why? The battle between the bulls and the bears becomes more intense and the suspense builds as the upper and lower parts of the triangle get closer together. Obviously, at some point, prices are going to move outside of the triangle’s boundaries – but will they move higher or lower? Psychological energy coils up like a spring inside of the triangle and the closer the lines get, the bigger the inevitable breakout will be.
As you probably guessed, the diagrams above are not realistic. Triangle patterns typically have a breakout well before the triangle reaches its apex. When observing a triangle form, the most important question to ask is which way the breakout is going. Which team will prevail? Will the bears win?
A couple of clues can be found in the price action that precedes the triangle. If the stock was in an uptrend prior to the triangle, there is a good chance it will break out of the triangle pattern on the upside and continue the uptrend. In addition, rising triangles tend to break out to the upside while descending triangles often break lower. Symmetric triangles are usually not completely even, i.e., the support side may be stronger than the resistance side making the triangle point up or, if the support side is weaker, point down. The triangle frequently breaks in that case in the direction it is pointing.
In part 12 we’ll look at how to confirm these patterns with volume and examine some real-world examples.
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