The question about how to recognize 'patterns' that suggest, for example the recent top assuming it is one, even an interim one, is not infinite but there are a few key factors that I look at. I suggested in my recent (Saturday, 8/15) Index Wrap
column that the price and indicator patterns looked like a top was forming.
After yesterday's (Monday's) break, my Saturday call looks more likely, irrespective of today's (Tuesday's) bounce back. Stay tuned on what happens next as this market has been fairly resistant to much of a pullback. But it always or usually looks like corrections will 'never' happen in a strong market. Until they do! Then the business media talking heads or their guests will tell you all the reasons why this is happening.
I looked in my (Essential Technical Analysis) book and other sources for a good definition of pattern recognition; yes, yes I look up stuff in my own book sometimes.
I couldn't find a good definition of pattern recognition exactly although I did have this glossary entry for pattern recognition system as: "A trading system that is based on a particular chart or price pattern and not based on trend following or moving average system. This type of trading system measures trend direction and duration. The trigger for market action is based on the formation of the pattern itself (e.g., a key reversal) and can be triggered rather quickly, rather than relying than reliance on a longer past period and averaging considerations".
The basis by which most of us rely on trading decisions is past experience in seeing other market trends and possible trend reversals in what look to be similar patterns. Trend reversals are the most important to me as once a market is trending it's somewhat of a no-brainer to 'follow' that trend, especially if itâ€™s a strong move. The trick with options trading, at least outright purchases of calls or puts, is to get into a new trend EARLY. Then it's much easier to stay with that trend as you bought 'right' and have a low cost basis relative to when the market is already in rip roaring move.
Pattern recognition is based on the fact that the market does have reoccurring short and intermediate-term trend reversals within overall major trends. Those trend changes often look similar to past ones in terms of price and indicator characteristics. Price patterns include aspects like well-recognized chart formations like double tops/bottoms, rectangles, Head & Shoulder's, etc. as well as trendline and price retracements aspects, etc. Major trends also reverse.
Indicator aspects of pattern recognition include ones attempting to measure overbought/oversold conditions or those utilizing contrary opinion models.
The principal elements I look to in attempting to recognize a possible trend reversal or trend consolidation only for that matter, are noted on my first chart, that of the S&P 500 (SPX).
TREND: If in an uptrend, we're going to look at prior UPtrends. I've looked at a relatively short period which is the CURRENT advance dating from early-March. I would look back to prior bull market trends but this article would be too long. In my mind, I'm building on years of experience at looking at corrections or trend reversals in up and down trends. Trend reversals in strong UP trends are DIFFERENT (e.g., take longer) than reversals in strong DOWN trends (e.g., occur suddenly).
PRICE PATTERNS: In this case, in examples 1-3 noted on the SPX chart below, prices went into a sideways trend, specifically that of trading range or rectangle pattern, after trending up previously.
TRENDLINES: There is an up trendline involved here that was a 'line' of support, but which, when pierced, became a type of rising trendline resistance.
RETRACEMENTS: Typically, in a strong trend, retracements of the prior move will only be about one-quarter to a fibonacci 38%. Weaker trends will tend to see retracements of one-half to even a fibonacci 62% or a 'little bit' more; i.e., 2/3rds or 66%.
OVERBOUGHT/OVERSOLD: I use the 13-day RSI on daily charts of the indexes; 21-hours on hourly charts, a 'length' setting of 8 typically on weekly or monthly charts. The other key aspect to just what is considered to be an 'overbought' or 'oversold' reading is to see where price/RSI divergences set up; i.e., prices go to new highs, but RSI doesn't and vice-versa.
SENTIMENT models: I use a daily volume ratio of total CBOE equities call volume divided BY total daily equities put volume, which gives me a whole number and where a HIGH reading is a kind of 'overbought' extreme and a LOW number is a kind of 'oversold' indication similar to the Relative Strength Index (RSI).
There are other aspects besides the ones listed above that sometimes come into play for me in the total pattern picture that suggest the outcome of a similar pattern(s) in terms of a trend reversal or pause; e.g. (Elliott) wave patterns sometimes. (Wave considerations most often tell us something about WHERE we are in the unfolding of a particular trend; e.g., expected trend STRENGTH and duration, versus suggesting an upcoming reversal.)
I'll zero on the following 3 highlighted patterns to go into the aforementioned aspects of pattern recognition or what we can also call aspects of pattern PREDICTION.
In the blown up SPX daily chart version that zeros in on the time frame for what I've labeled Pattern 1, the index went into a trading range or a sideways move, suggesting either a consolidation of the prior (up) trend or what could have been a rectangle top.
The only thing we can predict from price action ALONE is that the trend started going sideways as 2 or more highs and lows formed in similar areas. The trendlines connecting highs and lows are lateral ones, not slanted. The shape is that of a rectangle. Resolution of the trend is for prices to pierce the upper OR lower end of the box.
When we look at INDICATOR patterns for the chart above, the overbought readings of the RSI and high bullish sentiment suggest that the above rectangle pattern could be a TOP. We have to wait and see however as to the price direction (above or below the rectangle) that occurs in a next price swing.
Regardless of the high level registering in the RSI or the high bullish sentiment, the next price swing was UP; not by a lot as SPX only ran up 26 points to its next intraday peak, suggesting that the overbought condition was having some effect.
What is labeled PATTERN 2 below is of another sideways trend after the breakout move seen above. This is where the intraday SPX peak hit 956. Mostly the index was topping out around 950 or a little under. On the highest Closing high seen below, there was not a corresponding 'confirming' new high in the RSI, suggesting the possibility of a bearish price/RSI combination pattern.
Moreover, we got some further daily spikes of my Call to Put ratio into what I consider to be a bullish extremes suggesting a possible top; i.e., my CPRATIO hits levels at 1.7-1.9, or above.
The outcome of this second sideways trend or rectangle was a DOWNSIDE breakout.
An aspect of what happened AFTER the apparent downside breakout (from the rectangle) seen in 'pattern 2' concerns points related to a return to resistances implied by two types of trendlines as noted on the SPX chart below.
# 1 is what happened on a rebound back to the low end of the prior trading range or to that lower lateral trendline. # 2 is what was forecast by a further intraday rebound to the previously broken up trendline. Both lines acted as resistance. After these unsuccessful attempts to get back above resistance, the next move was a more 'normal' and deeper retracement of the prior advance as seen by the chart following the one immediately below.
From the 956 intraday top to the lowest low at 869, the retracement from peak to trough was more than 25%, but less than 38%, but in any case within my expectations of a 'normal' retracement seen in a STRONG trend. This is highlighted in my next chart. You'll see a further extension of the UP trendline, also acting as resistance, in my last chart.
In the most recent highlighted pattern, another sideways trend after a strong move (from the 869 low) that could be a consolidation of the existing trend or could be an interim top (I don't see it as a 'final' top by any means). In 'pattern 3', there is a break below the low end of the prior trading range or rectangle. This came after a more pronounced price/RSI divergence, which usually has bearish implications for a correction ahead.
Moreover, in my sentiment indicator are seen a cluster of even greater bullish extremes as noted by the red (down) arrows. Today's rebound has taken SPX back up to resistance implied by the low end of the prior trading range or rectangle. Tomorrow and the next day should tell the story as to whether SPX will get back above its area of prior support. I doubt that it will based on PAST patterns of this type.
Stay tuned as to whether the unfolding pattern is typical for what I anticipate or acts contrary to my expectations. It's always an unfolding drama with the market but certain patterns do suggest certain outcomes.
GOOD TRADING SUCCESS!