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A Most Useful Chart Pattern

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I got asked in a SUBSCRIBER MAIL the following question, which seemed like a good one to take off on today: "Hi. Is there a chart pattern you find the most useful in terms of trading direction"?

If I had to pick the single most useful chart pattern, there is one that we see relatively often and one that's very useful in terms of confirming that a trend is continuing: the 'flag' (consolidation) pattern. That is, 'bull' or 'bear' flags, which are also sometimes called pennants when they have a certain shape. Call em all flags I say!

I would also mention the single most useful chart 'marking': the trendline; which helps spot both a trend 'continuation' and, when pierced, a trend REVERSAL. For example, in my last Index Trader article, written this past weekend, I was speculating on a possible top in the S&P and Dow, based on this past week's high hitting a type of trendline that's parallel to an up trendline. In this instance that is the upper boundary of a bullish (uptrend) CHANNEL.

You can go to the aforementioned Index Trader column, which is seen online only, by clicking here.

A trendline is a straight line connecting at least, but preferably 3 or more lows (up trendline) or 3 or more highs (a down trendline). An internal trendline is a trendline that connects the MOST number of highs or lows, so may cut through one of more 'bar'; a bar on a bar or candlestick chart being the intraday, daily or weekly price range or distance between the high and low for that trading period. A channel line is a line parallel to a trendline that touches the highest high(s) (uptrend channel) or lowest low(s) (downtrend channel) for some preceding period of time.

The weekly uptrend channel for the S&P 500 (SPX) is seen below, but today's high is not seen yet. If it was it would not be the close of the WEEK until Friday 11/3. The down red arrow marks the touch of last week's high to the upper channel line. This may be a temporary top or prices may come back to it again later; or, of course, break out above the upper channel line later, which I think is the least likely possibility even though some would say that 'trendlines are made to be broken'. Channel lines, in this instance here, at least give us some idea of a possible stopping point or pause in the very strong rally we've been seeing. The BEST use of trendlines for providing a trading 'trigger' is however when you see them pierced or 'broken'.

The Dow 30 (INDU) has the same touch in last week's low to an upper channel line on the weekly chart, as seen below. The trendline we would focus on for a potential trend REVERSAL is the UP trendline. We would be watching this relatively steep trendline as to whether it gets pierced (or not); this trendline intersects currently at 11,875 at the green up arrow.

So, for this week, a downside penetration of 11875, especially on a closing basis would be a potential bearish reversal of the current intermediate uptrend. After such a lengthily run up as we've seen, I would be watching a much shorter INTRADAY timeframe and chart, with more bars, probably hourly, as to 1. highlighting a well-defined up trendline and 2. watching for the point where any such up trendline has gotten pierced:


A trendline can be drawn here on both a closing basis (a 'line' chart) or a standard 'bar' (or candlestick) chart. As it happens, the close-only hourly line chart sheen for SPX shown is very well-defined and has no closing hourly lows OUTSIDE the trendline so is not an 'internal' trendline. The break or decisive downside penetration of the up trendline came Friday, so the guts and glory went to those who went home short over the weekend.

The trendline seen on the hourly SPX chart shown below is an internal up trendline that cuts through a few of the hourly bars. The interesting thing about this draw of the trendline is that way that the return action of prices rebounding back up TO the trendline now acted as RESISTANCE. What had been support of the up trendline, once pierced, 'became' so to speak, a 'line' of resistance as seen at the red down arrow.


I started out to write about the most useful chart PATTERN, which I presenting one idea as being the 'flag' formation. 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. You will find these patterns more commonly in Indexes on INTRADAY charts; e.g., hourly/60 min.

In technical analysis, continuation patterns are 'consolidations' of the current trend. After an initial price spurt up or down, there is typically a countertrend or more or less sideways price movement before the trend renews itself and continues in the same direction as before this/these consolidation(s). The narrow ranges that comprise the price swings of the 'flag', have tops and bottoms that typically or often allow drawing trendlines across the highs and lows; the two resulting PARALLEL trendlines will usually if not always slope in the OPPOSITE direction from the trend.

In options trading the reason that such patterns have such value is that this pattern provides an idea that the trend will be continuing and becomes a guidepost suggesting to STAY with your position. And with a time limited instrument like options there is always the question we need answer as traders as to whether the existing trend will continue. The example of multiple flag patterns shown below the chart is that of a prime S&P 'bellwether' stock, that of General Electric (GE). GE will sometimes forecast a correction that is yet to show up in the Dow or S&P Index chart. This makes it a bellwether or harbinger for future market movement.

One clue, maybe not quite offering enough to put out a general index put buy recommendation, that the market wasn't likely to continue to rise here just recently (besides what I showed above in the move up to resistance implied by the upper trend channel boundary in SPX), was the formation of the above RECENT BEAR flag (example all the way right) in bellwether GE.

Prices rise or fall, there's a pause and a consolidation; if the pattern traced out is a flag pattern, it's also a suggestion that the next move will continue in the direction of the trend PRECEDING the formation of the flag. In the above example, GE peaked then fell some, rallied a bit and traded in the narrow range seen above (the upward sloping flag pattern), tipping us to a further decline that was coming.

A flag patterns outline is formed by a series of relatively narrow price range sessions after a relatively short, sometimes steep, price spurt; sometimes the 'straight up' or 'straight down' nature of this spurt resembles a 'flagpole' as is outlined in the GE chart above, with a vertical line. The next move, once prices break down below the up-sloping bear flag pattern above, could then equal the length of the flagpole measured below the downside 'breakout' point, which is how I noted the 'objective' in the chart above.



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