MY MAILBAG:

SUBJECT: Rectangle pattern.

"Can you say more about your last article on the rectangle chart type? what makes this a bottom or what about it makes for a top? don't you think that the euro crisis will determine the next move anyway? you mentioned about using how long the back and forth trading goes on to measure up how far the next move could go as not reliable? you wrot to look at the difference between the high and lows of trading range and guess on a next move equal to that if I understand this."

MY RESPONSE:

RECTANGLE PATTERN IN CHARTS:

Summarizing the questions/points made by our OIN Subscriber above:

1. What makes this pattern a bottom OR a top formation? 2. Isn't the validity of any chart pattern (suggesting a bottom or top) DETERMINED by the outcome of events such as whether Europe solves its financial crisis? Implied is why bother with trying to PREDICT which way this will go! 3. What is the way or ways to measure how high or low the NEXT move might be based on this chart pattern?

Going to the rationale of technical analysis, point #2 is about the validity of price target predictions suggested made by this, or any, chart pattern as subsequent economic/political events 'determine' market moves anyway. This is both true and not true. The market collectively has a 'mind set' so to speak about future economic outcomes that determine how stock prices will go. If this collective anticipation tips one way or another, a chart pattern may allow making predictions as to how events will unfold. Such predictions, based on thousands and thousands of prior observations, will often be on the mark. Sometimes they're not, which makes trading the challenge it is!

The question about whether a sideways trading range of 2-3 or more highs in the same area and 2-3 or more lows in the same area forming a rectangular chart pattern will precede a trend reversal, or is simply a consolidation of the prior/existing trend is unknowable; this would make the rectangle a continuation pattern. What we can forecast is how high or low the next move might be AFTER a breakout above or below the box-like pattern.

Some traders assume that if the trend was DOWN before the rectangle forms this represents a rectangle bottom and a reversal pattern. Or, if the trend was UP beforehand, the rectangle will lead to an downside reversal.

However, the rectangle, unlike say a Head & Shoulder's top formation, doesn't forecast a particular DIRECTIONAL next move. Chart examples follow where the rectangle was a pause before the prior trend resumed or where the pattern set up a reversal.

ALL CHARTS REFLECT CLOSES AS OF YESTERDAY, 10/26.

MEASURING THE NEXT PRICE SWING AFTER A RECTANGLE 'BREAKOUT'

There are some traders that will measure the 'width' of the sideways move and project that distance up the vertical price scale as a potential objective. This sometimes work and is an interesting exercise but this is not a very objective method as depending on the scaling of the chart, price targets will vary.

My next chart of Apple (AAPL) has bar spacing set to "2" (the bars are farther apart) and the aforementioned rule of thumb yields (after the breakout move) an objective that's higher than the objective implied above where bar spacing was more compressed. If the width of the rectangle becomes wider, it makes a target based on that width further UP the vertical price scale.

The conservative method for projecting a 'minimum' next move for AAPL after a breakout above or below the box is seen below. After a decisive upside or downside penetration of the rectangle, a next move is assumed to at least be equal to the prior price range; i.e., an equal next leg in the prior trend OR an equal move in the opposite direction.

With the S&P 500 (SPX) the rectangle pattern was assumed to represent a bottom after SPX broke out above 1220 (and rose above its prior up trendline). Therefore the rectangle here represents a REVERSAL type formation, as opposed to a 'continuation' pattern like Apple's seen above. SPX is trading around 1285, up 43 points, as I prepare to post this article.

The same rectangle bottom formation is seen with the Nasdaq Composite Index in my last chart. COMP is trading around 2743, up 93 points, as I finish up this article, which is still ahead of today's close.

This kind of power move is not untypical of the gains seen in stocks or the indexes after breakouts above/below the lengthily sideways trading range that technicians have described as a 'rectangle'; Charles Dow called the same pattern a line formation as on the more long-term charts weekly and monthly close-only charts he worked with, these things look more or less like a sideways 'line' that interrupts the trend for a time.

I'll next respond to a Subscriber on the question of the drawbacks relating to moving averages. ALL CHARTS REFLECT CLOSES AS OF YESTERDAY, 10/26.

SUBJECT: Moving Averages 3 disadvantages.

"In my line of work, I find people who may not understand the 3 major disadvantages of the Moving Average:

a) Data at the beginning and end are lost, this is due to how the moving averages are mathematicaly calculated, it is a sum of intergers divided by a "moving average of order N", in my experiences 3 seems to be the popular value for N;

b) Moving Averages may generate cycles or other movements that were not present in the orginal data;

c) Moving Averages are strongly affected by extreme values in the data, that is an "outlier", and has a tendency to shift up/down the trend line's.

Have you experienced any of these problems, if so what was the cure? I have a real problem of "removing" data from my list, which is the main problem I have with the MovingAverage. Is there a good site that I can use to explore the problems with the MA?"

MY RESPONSE:

MOVING AVERAGES

You are right in saying that a moving average that's only based on averaging 3, 5 or 8 prior closes will have considerable limitations. However, moving averages that take into account a more substantial number of Closes (or averages more highs or lows) will product a chart reference or line that will often represent support, resistance or highlight trends that are accelerating away from the average in question.

I tend to use moving averages that average AT LEAST 21 prior Closes, whether they are hourly or daily ones, where single extremes or a cluster of them will not overly distort the 21-day, 50-day and 200-day simple moving averages. A moving average that uses only 3 data points (e.g., 3 daily or hourly closes only) is going to be a hair-trigger affair. There's not a good site for this specific topic that I know of. There are technical analysis articles and books that discuss the best use and misuse of moving averages for sure.

I don't like to remove data from my list at all and keep, for example, hundreds of days of HOURLY data. I don't know what else to say except that problems with any technical indicator is a relative thing and over time, I find that you need to get to know how to use them. Moreover, I don't rely on any particular or single indicator for making trading decisions.

I do like the 21-day (or 21-hour) moving average for the stock INDEXES, and 4% upper and lower moving average envelope 'bands' or lines on daily charts for the S&P and Dow and (generally) 5% moving average envelopes for the Nasdaq.

I adjust these envelope values up or down depending on volatility over a multiweek or multimonth period. This way of using moving averages tends to give me a pretty good idea where prices are 'extended' (by prices jumping outside the envelope values) on the upside or downside. I use the term "extended" to mean vulnerable to a correction or reversal of at least the short-term trend. From the area of such upper or lower envelopes, prices will tend to return to the moving average in the 'center' of the upper and lower envelopes; e.g., back toward the 21-day average, functioning as the mean so to speak.

The following chart of the Nasdaq Composite will illustrate some of the ideas I've outlined on the use of the 21-day moving average in the stock indexes where envelope values that 'float' above/below the Average by a set percentage which you input are useful in defining trading/price parameters or broad support or resistance areas. The fact that prices can and do go above/below these outer bands doesn't negate their usefulness in evaluating more 'typical' price swings. The use of such longer moving averages, well above the shorter 'length' settings mentioned, is helpful in assessing where bottoms or tops may be forming.

Individual stocks are another story as to what length settings to use. I tend to use the widely followed 50 and 200-day moving averages and note if a stock is trading above OR below the average. As a technical person (engineer?) you may be looking for objective values and measurements, whereas the market is a pretty subjective affair.

Nevertheless, often these longer-term moving averages, specifically the 50 and 200-day ones are quite accurate in suggesting an area of support or resistance in individual stocks. This is highlighted numerous times on Boeing's (BA) daily chart seen next. The decline to the $58 area was followed by a series of up and down price swings. Three subsequent tops reversed at the 50-day average; this in turn was followed by a move to above this key average, which was then followed by a pullback to the 50-day average which now acted as support. Resistance once penetrated, tends to 'become' subsequent support and the reverse occurs where support, once pierced, becomes later resistance.

The aforementioned sideways move represented by several trading swings in the stock set up an apparent rectangle bottom which is also highlighted on BA's chart and is the perfect note to go into my next response to the query on 'RECTANGLES'.


GOOD TRADING SUCCESS!