Option Investor
Trader's Corner

More on 'High Potential' Chart Patterns

HAVING TROUBLE PRINTING?
Printer friendly version

Last Wednesday I wrote on some of the key chart patterns with the most predictable outcomes. There was an MIT study that I cite in my (Essential Technical Analysis) book that found, after an extensive statistical study, 5 patterns with an unusually high potential of predicting trend direction after the pattern forms, as well as price objectives in some cases.

An idea of a price objective is the holy grail of trading, especially for option traders. If you can project a price target with some degree of probable success that it will be achieved, this can lead to a very profitable trade. Moreover, you have the possibility of trading a larger position than usual, such as double; assuming of course that you always set and adhere to, as much as market conditions will allow, a pre-set risk, exit or stop point (however you do it, you get out when the index or stock goes a certain amount against your entry price).

By the way, my last Wednesday's Trader's Corner article is found in your 9/20 saved Option Investor Daily e-mail, assuming you keep them (a good idea, at least for awhile) or which can be seen online by clicking here.

I'm continuing on with this topic of 'high potential' price or chart patterns as I didn't cover the #5 pattern noted below, the 'broadening' formation yet AND because something interesting happened in the intervening week regarding developments that related to whether an implied Head & Shoulder's (pattern 1 below) upside objective would be realized in the S&P 500 (SPX) index OR whether a possible Double Top (pattern 2) was setting up in the same index.

It wasn't that the patterns were in 'conflict' or anything, only that it wasn't clear (as of last Wednesday) whether the Double Top would be 'confirmed' or whether there would be another move up through the prior price peak and the 'minimum' upside objective implied by the Head & Shoulder's bottom would be realized. On balance, you have to assume that a trend in motion will STAY in motion, but an overbought market at a prior significant high is a toss up choice as to stay with a position or not particularly in a time sensitive and limited instrument like options or futures.

The 5 chart patterns in discussion are:
1. The Head & Shoulder's (H&S) pattern, especially the H&S top pattern
2. The Double Top
3. The 'rectangle' top
4. The 'rectangle' bottom
5. The 'broadening' formation

THE S&P CHARTS AND H&S UPSIDE OBJECTIVES:

When the triple bottom pattern of a low, a lower low, followed by another higher low forms, this could be the classic Head & Shoulder's bottom. A 'confirming' indication that this pattern is a major bottom is a rally that pierces the so-called 'neckline', the down trendline noted on the S&P 100 (OEX) chart below.

When the neckline/down trendline is pierced, the price distance from the bottom of the Head (H) to the neckline is added to the bottom of the Right Shoulder (RS). This distance measured up the vertical price scale comes out to 612 in the OEX; this then becomes a 'minimum' upside objective. Of course the move can continue, as it's done. The 'measured' objective is a guideline or rule of thumb; an objective that is often realized and then some, which has happened with the strong further move up in the OEX to the 620 area today.

In a related note, it VERY often true that early stage prolonged rallies, as opposed to prolonged BULL MARKETS, are characterized by the ABSENCE of extreme bullishness; this aspect is seen above in my 'sentiment' indicator, a ratio of CBOE daily equities call volume relative to daily put volume. You'll note the lack of an extreme 'bullish' reading, which would be the case if the (blue) ratio line got to a reading that reached or exceeded the upper horizontal (red) line; this occurs when daily equities call volume is at least double daily put volume.

This aforementioned phenomena is what is meant by the saying that the market climbs a 'wall of worry'; e.g., the economy is slowing which will act as a drag on earnings, but this against the background effect of the Federal Reserve ceasing to raise interest rates. This implies a soft landing and this hope starts a process of institutional money coming in to raise stock weightings, against the backdrop of individual investors' worry about future earnings. It has most typically been true that markets don't top out in a major way until 'main street' and the individual investor gets quite bullish on equities. You see the attitude of individual market participants best in my estimation in equities options activity.

THE S&P 500 CHART AND A POSSIBLE 'DOUBLE TOP'

The S&P 500 (SPX) Index has been the lead index for the recent market cycle and SPX went up to its prior high and stalled. This presented the picture of a POSSIBLE double top. I emphasize the 'possible' aspect of this, because there is a confirming event that must occur to suggest that a double top is in place, just as there is a 'confirming' breakout action that must occur to suggest that a Head & Shoulder's bottom has developed.

In the SPX daily chart below, note the first high at the red down arrow and its notation of a 'possible double top'. SPX dropped back to the pivotal 21-day moving average but quickly rebounded, which was bullish. For a double top to be 'confirmed' so to speak, the decline would have needed to continue lower and at some point pierce the last/prior downswing low at 1290. This level was noted in my recent market musings as the double top 'confirmation' point or level. Never happened.

Instead of course SPX shot right back up and decisively penetrated the prior highs (the possible double top) and keep going. It kept going in fact until the SPX index ALSO reached the 1335 'minimum' H&S bottom upside target; an objective that was based on the upside measuring rule of thumb that I described for the OEX H&S bottom above. That is, once the neckline was pierced, a 'minimum' upside objective was equal to the distance from the Head to the neckline ADDED to the Right Shoulder and measured up the vertical price scale. This came out to 1335. You might not have thought this back when SPX was trading in the 1270 area!

Carrying this thought further on the double top. IF a decline in the SPX had carried to below 1290 on a closing basis, this event would 'confirm' the likelihood that the intermediate trend had reversed (from up to down). Any measuring implications for a down side objective?

First, the possible double top should be several weeks to a year apart. This fit the SPX certainly. Second, top reversals, such as the double top, perform poorly in a bull market. There must be a wait until prices fall under the confirmation point.

With index options, I always wait for this confirmation to think about going short or buying puts. However, if I am in Index calls bought at the breakout point (at the H&S neckline) OR when I see the 3rd low (RS) form (a good bet), I will tend to exit all of most of my calls as soon as it appears that a double top may form.

A good defensive move, as the further upside from the breakout above the prior pair of highs is probably equal to a third or less of the move that has already occurred; AND the risk of a shakeout grows, OR just that a sideways or lateral move will develop, which also tends to be the kiss of death when holding calls when trading for the intermediate moves or the intermediate trends.

I didn't note if there is a rule of thumb on the percent decline IF there is a 'confirmed' double top. No, but the average decline of 'successful' double top patterns is around 20% in stocks.

BROADENING BOTTOMS (AND TOPS):

The broadening formation - a broadening top or broadening bottom, is of interest as a chart pattern we see sometimes in the indexes and more often in stocks, although its not the most common pattern either. The broadening top or bottom are both made up of a series of higher highs and lower lows and the two trendlines that can be drawn give the appearance of a megaphone.

An example of a broadening top from my chart archive, in this case that of an hourly Dow chart:

Another historical example was seen in my book (Essential Technical Analysis) involving an individual stock at the time and shows the measuring implications of the broadening pattern, which is to add the price distance covered by the widest part of the pattern to the 'breakout' point; this becomes a 'minimum' upside objective.

The broadening 'megaphone' shaped pattern can suggest either a top or bottom and which it is, is dependent on which way the breakout goes, up or down. However, like the rectangle top or bottom, when its a trend REVERSAL pattern, the direction of the trend going INTO the formation of the trend usually provides the dominant clue; this was UP into the broadening TOP seen in the hourly Dow chart above and DOWN into the broadening BOTTOM see in the chart of the late-90's stock chart example:

If this pattern was more common I would spend more time on examples. I will however look at my individual stock charts in the coming weeks for any other examples I see of either the broadening top or bottom; given a rising market, I would of course anticipate more examples, if any, of the broadening bottom than the broadening top.

** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for answer in Trader's Corner articles to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.
 

Trader's Corner Archives