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Some chart patterns helpful to trading

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A Subscriber question got me thinking about some recent patterns seen in the indexes that suggested trading opportunities in the indexes. I will describe recent "flag" patterns, rounding tops, and the Head & Shoulder's top.

These patterns however can form either as part of an uptrend OR downtrend. They can either be REVERSAL type patterns like the rounding formation; either a rounding bottom or rounding top. The Head & Shoulder's (H&S) is also, most commonly, suggesting an upcoming reversal of trend; either an inverse H&S bottom or a H&S Top.

A flag pattern is usually a CONTINUATION type pattern. That is, a pattern that is a consolidation in an uptrend (bull flag) where a pullback is going to lead to a continuation of the existing UP trend; or a flag pattern that is a rebound that will lead to a continuation of an existing DOWN trend. So, there are bull and bear flags.

Either reversal patterns or continuation patterns suggest a new trading opportunity, an exit to an existing index option position or can suggest that the trade you are in is OK to stick with.

FLAG PATTERNS
Flag patterns are fairly common continuation patterns and are considered bullish in an uptrend and bearish in a declining trend. I say "common", but they are most common in individual stocks, somewhat less so in the Indexes.

In technical analysis, continuation patterns are "consolidations" to the prior price swing. After an initial strong move up or down, there is typically a countertrend or sideways price movement before the trend renews itself and continues in the same direction as before the consolidation.

Flag patterns are relatively short-term sideways consolidations after a prior sharp move in prices. By short-term, I mean a matter of a few days or more, in the case of a daily chart; but not more than 10-12 trading periods, whether hours, days or weeks.

A flag patterns outline is formed by a series of relatively narrow price range sessions after this sharp and relatively short price spurt. Sometimes the more or less "straight up" or "straight down" nature of this spurt resembles a "flagpole" as is outlined in the chart below ...

You can draw parallel lines through the highs and lows (the back and forth movements) that occur near the end of the prior move. This could be a steep decline in the case of bear flag. If there is steep decline or advance, this is called the "flagpole" part of a bull or bear flag.

The flagpole sometimes will turn out to equal a minimum distance covered in the NEXT advance or decline, as measured from the breakout of the two parallel flag lines. Most often there is a slope to the lines in a direction OPPOSITE the direction of the dominant trend. The parallel lines however, can be parallel lines that go sideways.

The narrow ranges that comprise the price swings of the "flag", have tops and bottoms that allow drawing trendlines across the highs and lows. The two resulting trendlines will often slope in the opposite direction from the trend. You'll see examples where the two parallel lines cut through one or two highs or lows. The idea is to connect the most number of highs or lows; called an "internal" or best-fit trendline.

A flagpole is imagined when there is an especially steep move that takes place over 2-3 trading periods. The distance covered by the decline, noted as the "flagpole" above, will sometimes equal the distance covered by a next decline, as measured at the point where a next downswing penetrates the lower flag line seen at the green arrow in the S&P 500 (SPX) chart above.

MEASURING A FLAG OBJECTIVE -
The measurement implication for the height of a further move, after the breakout from the flag consolidation, is that a minimum upside or downside objective is equal to the height of the "flagpole" subtracted from the downside breakout of a bear flag.

In the case of the SPX chart above, this measuring rule of thumb implies an objective to around 1100. These price target objectives of course are not always met but there is at least usually good downside follow through on the second break. The 1100 area is also of course a likely major support.

However, chart patterns can't just be viewed in isolation. We can see on the RSI (Relative Strength Index) indicator shown on the bottom of the chart above that the S&P 500 is no longer overbought, arguing against a further decline of this magnitude; i.e., to the 1100 area.

The most significant technical consideration arguing against that much of a further decline is the fact that SPX has retraced around 66% of the last big advance. I'm inclined to BUY retracements that are between 62 and 66% of a prior big move, setting my exit point that is risking to just under the 66% retracement line. Relative to this small risk, there is good potential for a continuation of the major up trend. One key is to wait for a breakout below the low end of the flag before figuring there could be another down leg.

ANOTHER INDEX CHART WITH LOTS OF FLAGS ...

A ROUNDING TOP -
The Dow 30 (INDU) hourly chart, as shown below, formed this pattern before its last sharp decline. It was the S&P related index that most showed this kind of rounding formation. It also happened to form a Double Top, which is also a potent technical indication that the trend could reverse.

The tip off for a further decline is when prices start another waterfall type decline, about half way down the side of the implied circle. If the accelerated fall begins by piercing the low end of trading range (at the blue dashed level line), it is a good indication of the start of another down leg ...

The rounding top (or rounding bottom) is not seen all that much in the indices, but when it is the pattern has a high predictive value in suggesting that prices are going to have a sharp further move down, in this case.

Sometimes another measuring rule of thumb will work to make an educated guess for a downside target when a decline carries the same distance as the width of the sideways consolidation that preceded the fall. In the chart, above distance "b" equaled distance "a".

Long term and major rounding tops sometimes set up on weekly charts. A prime example is the major market top that is outlined in the S&P 100 (OEX) chart below ...

Never being one to NOT reinforce key technical principles, the OEX weekly chart above is also a good example of support, once broken, becoming resistance later on. This was the return to the "line" of prior support at the red down arrow.

Opps, I dream of going back to buy more puts at that major 2000 top! Sorry, let's go back to the present. A rounding top also formed in the hourly chart of the Nasdaq Composite (COMP) back in late-March to early-April as seen below ...

The pattern in the hourly COMP chart above could also be viewed as a Head & Shoulder's (H&S) Top. I will show this pattern (the H&S Top) on the Nasdaq 100 (QQQQ) tracking stock next.

THE HEAD & SHOULDERS PATTERN
The Head & Shoulders pattern may be one of best known chart formations. It's a pattern that is also a "reversal" type chart formation, signaling at least a temporary trend reversal. The H&S patterns are valuable as they have a pretty high reliability for signaling a top (or bottom) ahead of when that actually happens, giving some time to prepare for it with a trading plan, especially important with Index options.

The H&S pattern can develop over days or weeks in individual stocks or stock indexes; or, in any other timeframe such as on an hourly chart such as seen in the QQQQ chart below ...

The Head and Shoulders TOP formation is composed of 3 tops prior to a downside trend reversal -- the middle peak (the Head) stands above the first and last tops; the Left (LS) and Right Shoulders (RS) tend to form in approximately the same price area.

Head and shoulders top pattern, as is true of other top and bottom patterns like the rounding formation or double tops (or bottoms), are more likely to occur after a trend has been underway for some time.

The Head and Shoulders bottom is also called an INVERSE Head and shoulders and is a mirror image of the head and shoulders top. It is similar to a triple bottom in that there are 3 lows, but with the middle low (the Head) being lower than the left and right lows.

MEASURING IMPLICATIONS
As shown above on the recent QQQQ chart, the distance from the top of Head to the dashed trendline called the neckline, once pierced, is ADDED to the point where the downside penetration occurs. This becomes a "minimum" downside objective.

If you were short QQQQ in the 36 area you probably don't want to cover shorts and exit your trade just because a minimum downside target was reached. However, the fact such a minimum downside objective was reached should put you on alert to exit as soon as there are signs of an upside reversal. This occurred at the upside penetration of the hourly down trendline at the red down arrow on the chart above.

This trade would have a profit of at least $2. Some traders will short just after what appears to be a right shoulder forms and could have gained more on the trade. Initial "risk" was small. As soon as the neckline was penetrated, an exiting (buy) stop should have been placed just above the down trendline.

That's all on recent bearish Index patterns. Spotting one of the top patterns, or seeing the bearish implication of the flag formation, could have led to some right (i.e., profitable) trading decisions.

Good Trading Success!

NOTE -
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.
 

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