Ascending Triangle (Continuation)The ascending triangle is a bullish formation that usually forms during an uptrend as a continuation pattern. There are instances when ascending triangles form as reversal patterns at the end of a downtrend, but they are typically continuation patterns. Regardless of where they form, ascending triangles are bullish patterns that indicate accumulation.
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Because of its shape, the pattern can also be referred to as a right-angle triangle. Two or more equal highs form a horizontal line at the top. Two or more rising troughs form an ascending trend line that converges on the horizontal line as it rises. If both lines were extended right, the ascending trend line could act as the hypotenuse of a right triangle. If a perpendicular line were drawn extending down from the left end of the horizontal line, a right triangle would form. Let's examine each individual part of the pattern and then look at an example.
Trend: In order to qualify as a continuation pattern, an established trend should exist. However, because the ascending triangle is a bullish pattern, the length and duration of the current trend is not as important as the robustness of the formation, which is paramount.
Top Horizontal Line: At least 2 <gl reaction high>reaction highs<gl> are required to form the top horizontal line. The highs do not have to be exact, but they should be within reasonable proximity of each other. There should be some distance between the highs, and a reaction low between them.
Lower Ascending Trend Line: At least two reaction lows are required to form the lower ascending trend line. These reaction lows should be successively higher, and there should be some distance between the lows. If a more recent reaction low is equal to or less than the previous reaction low, then the ascending triangle is not valid.
Duration: The length of the pattern can range from a few weeks to many months with the average pattern lasting from 1-3 months.
Volume: As the pattern develops, volume usually contracts. When the upside breakout occurs, there should be an expansion of volume to confirm the breakout. While volume confirmation is preferred, it is not always necessary.
Return to Breakout: A basic tenet of technical analysis is that resistance turns into support and vice versa. When the horizontal resistance line of the ascending triangle is broken, it turns into support. Sometimes there will be a return to this support level before the move begins in earnest.
[*]Target: Once the breakout has occurred, the price projection is found by measuring the widest distance of the pattern and applying it to the resistance breakout.
In contrast to the symmetrical triangle, an ascending triangle has a definitive bullish bias before the actual breakout. If you will recall, the symmetrical triangle is a neutral formation that relies on the impending breakout to dictate the direction of the next move. On the ascending triangle, the horizontal line represents overhead supply that prevents the security from moving past a certain level. It is as if a large sell order has been placed at this level and it is taking a number of weeks or months to execute, thus preventing the price from rising further. Even though the price cannot rise past this level, the reaction lows continue to rise. It is these higher lows that indicate increased buying pressure and give the ascending triangle its bullish bias.
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Primus Telecom (PRTL)http://stockcharts.com/images/minilink_sc.gif formed an ascending triangle over a 6-month period before breaking resistance with an expansion of volume.
From a low of 8.88 in April, the stock established an uptrend by forming a higher low at 8.94 and advancing to a new reaction high early June. (The beginning of the trend is not included on this chart.) After recording its highest price in 10 months, the stock met resistance at 24.
In June, the stock hit resistance at 23 a number of times and then again at 24 in July. The stock bounced off 24 at least three times in 5 months to form the horizontal resistance line. It was as if portions of a large block were being sold each time the stock neared 24.
The reaction lows were progressively higher, and formed an ascending trend line. The first low in May, 1999, occurred with a large spike down to 12.25, but the trend line was drawn to connect the prices grouped around 14. The ascending trend line could have been drawn to start at 12.25 and this version is shown with the gray trend line. The important thing is that there are at least two distinct reaction lows that are consecutively higher.
The duration of the pattern is around 6 months, which may seem a bit long. However, all the key ingredients for a robust pattern were in place.
Volume declined from late June until early October. There was a huge expansion when the stock fell from 23.44 (point 6) to 19.38 on two heavy trading days in October. However, this was only for two days and the stock found support around 20 to form a higher low. In keeping with the ideal pattern, the next expansion of volume occurred in early November when the stock broke resistance at 24. The stock traded at above average volume 7 of the 10 days surrounding the breakout, and all 7 were up days. Chaikin Money Flow dragged a bit from the two heavy down days, but recovered to +20% five days after the breakout.
The stock advanced to 30.75 before pulling back to around 26. Support was found above the original resistance breakout, and this indicated underlying strength in the stock.
[*]The initial advance was projected to be 10 (24 -14 = 10) points from the breakout at 24, making a target of 34. This target was reached within 2 months, but the stock didn't slow down until reaching 50 in March (not shown). Targets are only meant to be used as guidelines, and other aspects of technical analysis should also be employed for deciding when to sell.
Symmetrical Triangle (Continuation)The symmetrical triangle, which can also be referred to as a coil, usually forms during a trend as a continuation pattern. The pattern contains at least two lower highs and two higher lows. When these points are connected, the lines converge as they are extended and the symmetrical triangle takes shape. You could also think of it as a contracting wedge, wide at the beginning and narrowing over time.
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While there are instances when symmetrical triangles mark important trend reversals, they more often mark a continuation of the current trend. Regardless of the nature of the pattern, continuation or reversal, the direction of the next major move can only be determined after a valid breakout. We will examine each part of the symmetrical triangle individually, and then provide an example with Conseco.
Trend: In order to qualify as a continuation pattern, an established trend should exist. The trend should be at least a few months old and the symmetrical triangle marks a consolidation period before continuing after the breakout.
Four (4) Points: At least 2 points are required to form a trend line and 2 trend lines are required to form a symmetrical triangle. Therefore, a minimum of 4 points are required to begin considering a formation as a symmetrical triangle. The second high (2) should be lower than the first (1) and the upper line should slope down. The second low (2) should be higher than the first (1) and the lower line should slope up. Ideally, the pattern will form with 6 points (3 on each side) before a breakout occurs.
Volume: As the symmetrical triangle extends and the trading range contracts, volume should start to diminish. This refers to the quiet before the storm, or the tightening consolidation before the breakout.
Duration: The symmetrical triangle can extend for a few weeks or many months. If the pattern is less than 3 weeks, it is usually considered a pennant. Typically, the time duration is about 3 months.
Breakout Time Frame: The ideal breakout point occurs 1/2 to 3/4 of the way through the pattern's development or time-span. The time-span of the pattern can be measured from the apex (convergence of upper and lower lines) back to the beginning of the lower trend line (base). A break before the 1/2 way point might be premature and a break too close to the apex may be insignificant. After all, as the apex approaches, a breakout must occur sometime.
Breakout Direction: The future direction of the breakout can only be determined after the break has occurred. Sound obvious enough, but attempting to guess the direction of the breakout can be dangerous. Even though a continuation pattern is supposed to breakout in the direction of the long-term trend, this is not always the case.
Breakout Confirmation: For a break to be considered valid, it should be on a closing basis. Some traders apply a price (3% break) or time (sustained for 3 days) filter to confirm validity. The breakout should occur with an expansion in volume, especially on upside breakouts.
Return to Apex: After the breakout (up or down), the apex can turn into future support or resistance. The price sometimes returns to the apex or a support/resistance level around the breakout before resuming in the direction of the breakout.
[*]Price Target: There are two methods to estimate the extent of the move after the breakout. First, the widest distance of the symmetrical triangle can be measured and applied to the breakout point. Second, a trend line can be drawn parallel to the pattern's trend line that slopes (up or down) in the direction of the break. The extension of this line will mark a potential breakout target.
Prices sometimes return to the breakout point of apex on a reaction move before resuming in the direction of the breakout. This return can offer a second chance to participate with a better reward to risk ratio. Potential reward price targets found by measurement and parallel trend line extension are only meant to act as rough guidelines. Technical analysis is dynamic and ongoing assessment is required. In the first example above, SUNW may have fulfilled its target (42) in a few months, but the stock gave no sign of slowing down and advanced above 100 in the following months.
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The stock declined from 50 in Mar-98 to 22 in Oct-98 before beginning to firm and consolidate. The low at 22 probably was an over-reaction, but the long-term trend was down and established for almost a year.
After the first 4 points formed, the lines of the symmetrical triangle were draw. The stock traded within the boundaries for another 2 months to form the last 2 points.
After the gap up from point 3 to point 4, volume slowed over the next few months. There was some increase in volume in late June, but the 60-day SMA remained in a downtrend as the pattern took shape.
The red square marks the ideal breakout time-span from 50% to 75% of the pattern. The breakout occurred a little over 2 weeks later, but proved valid nonetheless. While it is preferable to have an ideal pattern develop, it is also quite rare.
After points 5 and 6 formed, the price action moved to the lower boundary of the pattern. Even at this point, the direction of the breakout was still a guess and its was prudent to wait. The break occurred with an increase in volume and accelerated price decline. Chaikin Money Flow declined past -30% and volume exceeded the 60-day SMA for an extended period.
After the decline from 29 1/2 to 25 1/2, the stock rebounded, but failed to reach potential resistance from the apex. The weakness of the reaction rally foreshadowed the sharpness of the decline that followed.
[*]The widest point on the pattern extended 10 1/2 points. With a break of support at 29 1/2, the measured decline was estimated to around 19. By drawing a trend line parallel to the upper boundary of the pattern, the extension estimates a decline to around 20.
Descending Triangle (Continuation)The descending triangle is a bearish formation that usually forms during a downtrend as a continuation pattern. There are instances when descending triangles form as reversal patterns at the end of an uptrend, but they are typically continuation patterns. Regardless of where they form, descending triangles are bearish patterns that indicate distribution.
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Because of its shape, the pattern can also be referred to as a right-angle triangle. Two or more comparable lows form a horizontal line at the bottom. Two or more declining peaks form a descending trend line above that converges with the horizontal line as it descends. If both lines were extended right, the descending trend line could act as the hypotenuse of a right triangle. If a perpendicular line were drawn extending up from the left end of the horizontal line, a right triangle would form. Let's examine each individual part of the pattern and then look at an example.
Trend: In order to qualify as a continuation pattern, an established trend should exist. However, because the descending triangle is definitely a bearish pattern, the length and duration of the current trend is not as important. The robustness of the formation is paramount.
Lower Horizontal Line: At least 2 reaction lows are required to form the lower horizontal line. The lows do not have to be exact, but should be within reasonable proximity of each other. There should be some distance separating the lows and a reaction high between them.
Upper Descending Trend Line: At least two reaction highs are required to form the upper descending trend line. These reaction highs should be successively lower and there should be some distance between the highs. If a more recent reaction high is equal to or greater than the previous reaction high, then the descending triangle is not valid.
Duration: The length of the pattern can range from a few weeks to many months, with the average pattern lasting from 1-3 months.
Volume: As the pattern develops, volume usually contracts. When the downside break occurs, there would ideally be an expansion of volume for confirmation. While volume confirmation is preferred, it is not always necessary.
Return to Breakout: A basic tenet of technical analysis is that broken support turns into resistance and visa versa. When the horizontal support line of the descending triangle is broken, it turns into resistance. Sometimes there will be a return to this newfound resistance level before the down move begins in earnest.
[*]Target: Once the breakout has occurred, the price projection is found by measuring the widest distance of the pattern and subtracting it from the resistance breakout.
In contrast to the symmetrical triangle, a descending triangle has a definite bearish bias before the actual break. The symmetrical triangle is a neutral formation that relies on the impending breakout to dictate the direction of the next move. For the descending triangle, the horizontal line represents demand that prevents the security from declining past a certain level. It is as if a large buy order has been placed at this level and it is taking a number of weeks or months to execute, thus preventing the price from declining further. Even though the price does not decline past this level, the reaction highs continue to decline. It is these lower highs that indicate increased selling pressure and give the descending triangle its bearish bias.
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After recording a lower high just below 60 in Dec-99, Nucorhttp://stockcharts.com/images/minilink_sc.gif formed a descending triangle early in 2000. In late April, the stock broke support with a gap down, sharp break and increase in volume to complete the formation.
The stock declined from above 60 to the low 40s before finding some support and mounting a reaction rally. The rally stalled just below 50 and a series of lower reaction highs began to form. The long-term trend was down and the resulting pattern was classified as continuation.
Support at 45 was first established with a bounce in February. After that, the stock touched this level two more times before breaking down. After the second touch in March (about a month later), the lower support line was drawn.
After each bounce off support, a lower high formed. The reaction highs at points 2,4 and 6 formed the descending trend line to mark the potential descending triangle pattern. I say potential because the pattern is not complete until support is broken.
The duration of the pattern was a little less than 3 months.
The last touch of support at 45 occurred in late April. The stock spiked down through support, but managed to close above this key level. The final break occurred a few days later with a gap down, a considerable black candlestick and an expansion in volume. The way support is broken can offer insight into the general weakness of a security. This was not a slight break, but a rather convincing break. Volume jumped to the highest level in many months and money flows broke below -10%.
After falling from 45 to 41, the stock mounted a feeble reaction rally that only lasted three days and produced two candlesticks with long upper shadows. Sometimes there is a test of the newfound resistance level, and sometimes there isn't. A weak test of support can indicate acute selling pressure.
[*]The initial decline was projected to be 9 points (54 -45 = 9). If this is subtracted from the support break at 45, the downside projection is to around 36. Even though the stock exceeded this target in late June, recent strength has brought it back near 36. Targets are only meant to be used as guidelines and other aspects of technical analysis should also be employed for deciding when to cover a short or buy.
Rectangle (Continuation)A Rectangle is a continuation pattern that forms as a trading range during a pause in the trend. The pattern is easily identifiable by two comparable highs and two comparable lows. The highs and lows can be connected to form two parallel lines that make up the top and bottom of a rectangle. Rectangles are sometimes referred to as trading ranges, consolidation zones or congestion areas.
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There are many similarities between the rectangle and the symmetrical triangle. While both are usually continuation patterns, they can also mark trend significant tops and bottoms. As with the symmetrical triangle, the rectangle pattern is not complete until a breakout has occurred. Sometimes clues can be found, but the direction of the breakout is usually not determinable beforehand. We will examine each part of the rectangle and then provide an example with MU.
Trend: To qualify as a continuation pattern, a prior trend should exist. Ideally, the trend should be a few months old and not too mature. The more mature the trend, the less chance that the pattern marks a continuation.
Four (4) Points: At least two equivalent reaction highs are required to form the upper resistance line and two equivalent reaction lows to form the lower support line. They do not have to be exactly equal, but should be within a reasonable proximity. Although not a prerequisite, it is preferable that the highs and lows alternate.
Volume: As opposed to the symmetrical triangle, rectangles do not exhibit standard volume patterns. Sometimes volume will decline as the pattern develops. Other times volume will gyrate as the prices bounce between support and resistance. Rarely will volume increase as the pattern matures. If volume declines, it is best to look for an expansion on the breakout for confirmation. If volume gyrates, it is best to assess which movements (advances to resistance or declines to support) are receiving the most volume. This type of volume assessment could offer an indication on the direction of the future breakout.
Duration: Rectangles can extend for a few weeks or many months. If the pattern is less than 3 weeks, it is usually considered a flag, also a continuation pattern. Ideally, rectangles will develop over a 3-month period. Generally, the longer the pattern, the more significant the breakout. A 3-month pattern might be expected to fulfill its breakout projection. However, a 6-month pattern might be expected to exceed its breakout target.
Breakout Direction: The direction of the next significant move can only be determined after the breakout has occurred. As with the symmetrical triangle, rectangles are neutral patterns that are dependent on the direction of the future breakout. Volume patterns can sometimes offer clues, but there is no confirmation until an actual break above resistance or break below support.
Breakout Confirmation: For a breakout to be considered valid, it should be on a closing basis. Some traders apply a filter to price (3%), time (3 days) or volume (expansion) for confirmation.
Return to Breakout: A basic tenet of technical analysis is that broken support turns into potential resistance and visa versa. After a break above resistance (below support), there is sometimes a return to test this newfound support level (resistance level). (For more detail, see this article on support and resistance.) A return to or near the original breakout level can offer a second chance to participate.
[*]Target: The estimated move is found by measuring the height of the rectangle and applying it to the breakout.
Rectangles represent a trading range that pits the bulls against the bears. As the price nears support, buyers step in and push the price higher. As the price nears resistance, bears take over and force the price lower. Nimble traders sometimes play these bounces by buying near support and selling near resistance. One group (bulls or bears) will exhaust itself and a winner will emerge when there is a breakout. Again, it is important to remember that rectangles have a neutral bias. Even though clues can sometimes be gleaned from volume patterns, the actual price action depicts a market in conflict. Only until the price breaks above resistance or below support will it be clear which group has won the battle.
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In the summer of 1999, Micron Electronics (MU)http://stockcharts.com/images/minilink_sc.gif advanced from the high teens to the low forties. After meeting resistance around 42, the stock settled in a trading range between 40 and 30 to form a rectangle.
The prior intermediate trend was established as bullish by the advance from the high teens to the low forties. However, it was unclear at the time if this trading range would be a reversal or a continuation pattern. The horizontal resistance line at 40 can be extended back to the Feb-99 high and marked a serious resistance level.
The red resistance line at 40 was formed with three reaction highs. The first reaction high may be a bit suspect, but the second two are robust. The parallel support line at 30 was touched three times and established a solid support level. After the high at point 5 was reached, the rectangle was valid.
As the pattern developed, volume fluctuated and there was no clear indication (bullish or bearish break) until mid-February. The first bullish clue came when the stock declined from 38 to 31 and Chaikin Money Flow failed to move below -10%. Money flows held steady throughout the decline and turned positive as soon as the stock turned back up. By the time the stock reached 39 3/4 (surpassing its previous reaction high in the process), CMF was at +20%. Also notice the strength behind the advance after a higher low.
The duration of the pattern was 5 months. Due to long-term overhead resistance at 40, the pattern needed more time to consolidate before a breakout. The longer consolidation made for bigger expectations after the breakout.
The breakout occurred with a large expansion in volume and a huge moved above resistance.
After the breakout, there was a slight pullback to around 46, but the volume behind the advance indicated a huge breakout. Stocks do not always return to the point of breakout. In the example above, LMT makes a classic return to the breakout. The set up and strength behind the breakout should be assessed to determine the possibility of a second chance opportunity.
[*]The target advance of this breakout was 10 points, which was the width of the pattern. However, judging from the duration and strength of the breakout, expansion of volume and new all-time highs, it was apparent that this was no ordinary breakout. Therefore an ordinary target was useless! After an initial advance as high as 55 13/16, the stock pulled back to 46 and then moved above 70. Another trading range subsequently developed with resistance in the low 70s and support in the upper 40s.
Price Channel (Continuation)A price channel is a continuation pattern that slopes up or down and is bound by an upper and lower trend line. The upper trend line marks resistance and the lower trend line marks support. Price channels with negative slopes (down) are considered bearish and those with positive slopes (up) bullish. For explanatory purposes, a "bullish price channel" will refer to a channel with positive slope and a "bearish price channel" to a channel with negative slope.
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Main Trend Line: It takes at least two points to draw the main trend line. This line sets the tone for the trend and the slope. For a bullish price channel, the main trend line extends up and at least two reaction lows are required to draw it. For a bearish price channel, the main trend line extends down and at least two reaction highs are required to draw it.
Channel Line: The line drawn parallel to the main trend line is called the channel line. Ideally, the channel line will be based off of two reaction highs or lows. However, after the main trend line has been established, some analysts draw the parallel channel line using only one reaction high or low. The channel line marks support in a bearish price channel and resistance in a bullish price channel.
Bullish Price Channel: As long as prices advance and trade within the channel, the trend is considered bullish. The first warning of a trend change occurs when prices fall short of channel line resistance. A subsequent break below main trend line support would provide further indication of a trend change. A break above channel line resistance would be bullish and indicate an acceleration of the advance.
Bearish Price Channel: As long as prices decline and trade within the channel, the trend is considered bearish. The first warning of a trend change occurs when prices fail to reach channel line support. A subsequent break above main trend line resistance would provide further indication of a trend change. A break below channel line support would be bearish and indicate an acceleration of the decline.
[*]Scaling: Even though it is a matter of personal preference, trend lines seem to match reaction highs and lows best when semi-log scales are used. Semi-log scales reflect price movements in percentage terms. A move from 50 to 100 will appear the same distance as a move from 100 to 200.
In a bullish price channel, some traders look to buy when prices reach main trend line support. Conversely, some traders look to sell (or short) when prices reach main trend line resistance in a bearish price channel. As with most price patterns, other aspects of technical analysis should be used to confirm signals.
Because technical analysis is just as much art as it is science, there is room for flexibility. Even though exact trend line touches are ideal, it is up to each individual to judge the relevance and placement of both the main trend line and the channel line. By that same token, a channel line that is exactly parallel to the main trend line is ideal.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/pricechannel-csco.png
CSCOhttp://stockcharts.com/images/minilink_sc.gif provides an example of an 11-month bullish price channel that developed in 1999.
Main Trend Line: The January, February and March reaction lows formed the beginning of the main trend line. Subsequent lows in April, May and August confirmed the main trend line.
Channel Line: Once the main trend line was in place, the channel line beginning from the January high was drawn. A visual assessment reveals that these trend lines look parallel. More precise analysts may want to test the slope of each line, but a visual inspection is usually enough to ensure the "essence" of the pattern.
Bullish Price Channel: Subsequent touches along the main trend line offered good buying opportunities in mid April, late May and mid August.
The stock did not reach channel line resistance until July (red arrow) and this marked a significant reaction high.
The September high (blue arrow) fell short of channel line resistance, but only by a small margin that was probably insignificant.
[*]The break above channel line resistance in Dec-99 marked an acceleration of the advance. Some analysts might consider the stock overextended after this move, but the advance was powerful and the trend never turned bearish. Price channels will not last forever, but the underlying trend remains in place until proved otherwise.
Measured Move - Bullish (Continuation)The Measured Move is a three-part formation that begins as a reversal pattern and resumes as a continuation pattern. The Bullish Measured Move consists of a reversal advance, correction/consolidation and continuation advance. Because the Bullish Measured Move cannot be properly identified until after the correction/consolidation period, it is categorized as a continuation pattern. The pattern is usually long-term and forms over several months.
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Prior Trend: For the first advance to qualify as a reversal, there must be evidence of a prior downtrend to reverse. Because the Bullish Measured Move can occur as part of a larger advance, the length and severity of the prior decline may vary from a few weeks to many months.
Reversal Advance: The first advance usually begins near the established lows of the previous decline and extends for a few weeks or many months. Sometimes a reversal pattern can mark the initial trend change. Other times the new uptrend is established by new reaction highs or a break above resistance. Ideally, the advance is fairly orderly and lengthy with a series of rising peaks and troughs that may form a price channel. Less erratic advances are satisfactory, but run the risk of forming a different pattern.
Consolidation/Correction: After an extended advance, some sort of consolidation or correction can be expected. As a consolidation, there could be a continuation pattern such as a rectangle or ascending triangle. As a correction, there could be 33% to 67% retracement of the previous advance and the possible patterns include a large downward-sloping flag or falling wedge. Generally speaking, the bigger the advance, the bigger the correction. A 100% advance may see a 62% correction and a 50% advance may see only a 33% correction.
Continuation Advance - Length: The distance from the low to the high of the first advance can be applied to the low of the consolidation/retracement to estimate a projected advance. Some technicians like to measure by points, others in percentage terms. If the first advance was from 30 to 50 (20 points) and the consolidation/correction was to 40, then 60 would be the target of the second advance (50 - 30 = 20 : 40 + 20 = 60). For those who prefer percentages: if the first advance was from 30 to 50 (66%) and the consolidation/correction was to 40, then 66.40 would be the target of the second advance (40 X 66% = 26.40 : 40 + 26.40 = 66.40). The decision of which method to use will depend on the individual security and your analysis style.
Continuation Advance - Entry: If the consolidation/correction is made up of a continuation pattern, then second leg entry points can be identified using the normal breakout rules. However, if there is no readily identifiable pattern, then some other continuation breakout signal must be sought. In this case, much will depend on your trading style, objectives, risk tolerance and time horizon. One method might be to measure potential retracements (33%, 50%, or 62%) and look for short-term reversal patterns for good reward-to-risk entry points. Another method might be to wait for a break above the reaction high set by the first advance as confirmation of continuation. This method would make for a late entry, but the pattern would be confirmed.
[*]Volume: Volume should increase at the beginning of the reversal advance, decrease at the end of the consolidation/correction and increase again at the beginning of the continuation advance.
The Bullish Measured Move can be made up of a number of patterns. There could be a double bottom to start the reversal advance, a price channel during the reversal advance, an ascending triangle to mark the consolidation and another price channel to mark the continuation advance. During multi-year bull markets (or bear markets), a series of Bullish Measured Moves can form. While the projections for the continuation advance can be helpful for targets, they should only be used as rough guidelines. Securities can overshoot their targets, but also fall short – technical assessments should be ongoing.
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Intel (INTC)http://stockcharts.com/images/minilink_sc.gif broke out of a multi-year slump and began a Measured (Bull) Move.
Prior Trend: After a large downward sloping trading range throughout most of 1997 and 1998, Intel broke above resistance in early November (blue arrows) and started the first leg of a Measured (Bull) Move.
Reversal Advance: The breakout occurred with a strong move above resistance at 22 with 2 weeks of strong volume (green arrows). The advance began from 17.44 and ended at 35.92.
Consolidation/Correction: After an extended advance, the stock declined within a set range that resembled a large descending flag. The decline retraced about 54% of the previous advance.
Continuation Advance - Length: The estimated length of the advance was 18.48 points from the June low at 25.94, which would target 44.42. The actual high was 44.75 for a 18.81 advance.
Continuation Advance - Entry: Because the consolidation/correction portion formed a continuation pattern, entry could have been based on a break above the resistance line (red arrow).
[*]Volume: Volume increased in early November at the beginning of the reversal advance. There was a decrease from March to May 1999. And, volume increased at the beginning of the continuation advance (green arrows).
Measured Move - Bearish (Continuation)The Measured Move is a three-part formation that begins as a reversal pattern and resumes as a continuation pattern. The Bearish Measured Move consists of a reversal decline, consolidation/retracement and continuation decline. Because the Bearish Measured Move cannot be confirmed until after the consolidation/retracement period, it is categorized as a continuation pattern. The pattern is usually long-term and forms over several months.
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Prior Trend: For the first decline to qualify as a reversal, there must be evidence of a prior uptrend to reverse. Because the Bearish Measured Move can occur as part of a larger advance, the length and severity of the prior decline may vary from a few weeks to many months.
Reversal Decline: The first decline usually begins near the established highs of the previous advance and extends for a few weeks or many months. Sometimes this reversal pattern can mark the initial trend change, other times a new downtrend is established by new reaction lows or a break below support. Ideally, the decline is fairly orderly and lengthy with a series of declining peaks and troughs that may form a price channel. Less erratic declines are satisfactory, but run the risk of turning into a different pattern.
Consolidation/Retracement: After an extended decline, some sort of consolidation or retracement can be expected. As a retracement rally (or reaction rally), prices could recoup 33% to 67% of the previous decline. Generally speaking, the bigger the decline is, the bigger the reaction rally. Some retracement formations might include an upward sloping flag or rising wedge. If the formation turns out to be a consolidation, then a continuation pattern such as a rectangle or descending triangle could form.
Continuation Decline - Length: The distance from the high to the low of the first decline can be applied to the high of the consolidation/retracement to estimate the length of the next decline. Some technicians like to measure by points, others in percentage terms. If a security declines from 60 to 40 (20 points) and the consolidation/retracement rally returns to the security to 50, then 30 would be the target of the second decline (50 - 20 = 30). Using the percentage method, the decline from 60 to 40 would be -33% and projected decline from 50 would be 16.50. (50 X 33% = 16.50 : 50 - 16.5 = 33.50). Deciding which method to use will depend on the individual security and your analysis preferences.
Continuation Decline - Entry: If the consolidation/retracement forms a continuation pattern, then an appropriate second leg entry point can be identified using traditional technical analysis rules. However, if there is no readily identifiable pattern, then some other signal must be sought. In this case, much will depend on your trading preferences, objectives, risk tolerance and time horizon. One method might be to measure potential retracements (33%, 50% or 62%) and look for short-term reversal patterns. Another method might be to look for a break below the reaction low set by the first decline as confirmation of continuation. This method would make for a late entry, but the Measured (bear) Move pattern would be confirmed.
[*]Volume: Volume should increase during the reversal decline, decrease at the end of the consolidation/retracement and increase again during the continuation decline. This is the ideal volume pattern, but volume confirmation for bearish patterns is not as important as for bullish patterns.
More than one pattern can exist within the context of a Bearish Measured Move. A double top could mark the first reversal and decline, a price channel could form during this decline, a descending triangle could mark the consolidation and another price channel could form during the continuation decline.
During multi-year bear markets (or bull markets), a series of Bearish Measured Moves can form. A bear move consisting of three down legs might include a reversal and decline for the first leg, a retracement, a decline for the second leg, a retracement and finally the third leg decline.
While the projection targets for the continuation decline can be helpful, they should only be used as rough guidelines. Securities can overshoot their targets, but also fall short and technical assessments should be ongoing.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/measurebearmove-xirc.gif
As illustrated in the XIRCOM (XIRC)http://stockcharts.com/images/minilink_sc.gif chart above, the second decline of a Bearish Measured Move may not be as orderly as the first, especially when volatile stocks are involved.
Prior Trend: After a multi-year bull move, XIRC reached its all-time high at 69.69 on 31-Dec-99.
Reversal Decline: The stock broke trend line support in Jan-00 and a lower low was recorded when the stock dropped below 45 in Feb-00. The decline took the stock to 29.13 in Apr-00 for a total of 40.56 points down.
Consolidation/Correction: In April, May and June, the stock recouped about 50% of its previous decline with a retracement rally to 52.75. Including the spike high at 52.75, a parallel price channel formed (resembling a large flag) with support marked by the lower trend line. Excluding the spike high, the interpretation could have been a rising wedge. Either way, support was marked by the lower trend line.
Continuation Decline - Length: The estimated length of the continuation decline was 40.56 points from the June high at 52.75, which would target 12.19. Percentage estimates can sometimes be more applicable to Measured (Bear) Moves, especially if the target appears unusually low. The decline from 69.69 to 29.13 was 58%. A 58% decline from 52.75 would mark a target around 22.16 (52.75 x .58 = 30.59 : 52.75 - 30.59 = 22.16).
Continuation Decline - Entry: Because the consolidation/retracement portion formed a continuation pattern, entry could have been based on a break below the support trend line line (red arrows).
[*]Volume: Volume increased just prior to the trend line support break in Jan-00 and again when the stock broke below its previous reaction low (blue arrows). Later when the stock broke trend line support in July, volume also increased significantly (red arrows).
Cup with Handle (Continuation)The Cup with Handle is a bullish continuation pattern that marks a consolidation period followed by a breakout. It was developed by William O'Neil and introduced in his 1988 book, How to Make Money in Stocks.
As its name implies, there are two parts to the pattern: the cup and the handle. The cup forms after an advance and looks like a bowl or rounding bottom. As the cup is completed, a trading range develops on the right hand side and the handle is formed. A subsequent breakout from the handle's trading range signals a continuation of the prior advance.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/cuphandle-jbl.png
Trend: To qualify as a continuation pattern, a prior trend should exist. Ideally, the trend should be a few months old and not too mature. The more mature the trend, the less chance that the pattern marks a continuation or the less upside potential.
Cup: The cup should be "U" shaped and resemble a bowl or rounding bottom. A "V" shaped bottom would be considered too sharp of a reversal to qualify. The softer "U" shape ensures that the cup is a consolidation pattern with valid support at the bottom of the "U". The perfect pattern would have equal highs on both sides of the cup, but this is not always the case.
Cup Depth: Ideally, the depth of the cup should retrace 1/3 or less of the previous advance. However, with volatile markets and over-reactions, the retracement could range from 1/3 to 1/2. In extreme situations, the maximum retracement could be 2/3, which is conforms with Dow Theory.
Handle: After the high forms on the right side of the cup, there is a pullback that forms the handle. Sometimes this handle resembles a flag or pennant that slopes downward, other times just a short pullback. The handle represents the final consolidation/pullback before the big breakout and can retrace up to 1/3 of the cup's advance, but usually not more. The smaller the retracement is, the more bullish the formation and significant the breakout. Sometimes it is prudent to wait for a break above the resistance line established by the highs of the cup.
Duration: The cup can extend from 1 to 6 months, sometimes longer on weekly charts. The handle can be from 1 week to many weeks and ideally completes within 1-4 weeks.
Volume: There should be a substantial increase in volume on the breakout above the handle's resistance.
[*]Target: The projected advance after breakout can be estimated by measuring the distance from the right peak of the cup to the bottom of the cup.
As with most chart patterns, it is more important to capture the essence of the pattern than the particulars. The cup is a bowl-shaped consolidation and the handle is a short pullback followed by a breakout with expanding volume. A cup retracement of 62% may not fit the pattern requirements, but a particular stock's pattern may still capture the essence of the Cup with Handle.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/chart_patterns/cuphandle-emc.png
Trend: EMChttp://stockcharts.com/images/minilink_sc.gif established the bull trend by advancing from 10 and change to above 30 in about 5 months. The stock peaked in March and then began to pull back and consolidate its large gains.
Cup: The April decline was quite sharp, but the lows extended over a two month period to form the bowl that marked a consolidation period. Also note that support was found from the Feb-99 lows.
Cup Depth: The low of the cup retraced 42% of the previous advance. After an advance in June and July, the stock peaked at 32.69 to complete the cup (red arrow).
Handle: Another consolidation period began in July to start the handle formation. There was a sharp decline in August that caused the handle to retrace more than 1/3 of the cup's advance. However, there was a quick recovery and the stock traded back up within the normal handle boundaries within a week. I believe the essence of the formation remained valid after this sharp decline.
Duration: The cup extended for about 3 months and the handle for about 1 1/2 months.
Volume: In early Sept-00, the stock broke handle resistance with a gap up and volume expansion (green arrow). In addition, Chaikin Money Flow soared above +20%.
[*]Target: The projected advance after breakout was estimated at 9 points from the breakout around 32. EMC easily fulfilled this target over the next few months.
Candlesticks and SupportSingle candlesticks and candlestick patterns can be used to confirm or mark support levels. Such a support level could be new after an extended decline or confirm a previous support level within a trading range. In a trading range, candlesticks can help choose entry points for buying near support and selling near resistance. The list below contains some, but not all, of the candlesticks and candlestick patterns that can be used to together with support levels. The bullish reversal patterns are marked (R).
Bullish Engulfing (R)
Bullish Harami (R)
Doji (Normal, Long Legged, Dragonfly)
Hammer (R)
Inverted Hammer (R)
Long White candlestick or White Marubozu
Morning Star or Bullish Abandoned Baby (R)
Piercing Pattern (R)
Spinning Top
[*]Three White Soldiers (R)
Bullish reversal candlesticks and patterns suggest that early selling pressure was overcome and buying pressure emerged for a strong finish. Such bullish price action indicates strong demand and that support may be found.
The inverted hammer, long white candlestick and marubozu show increased buying pressure rather than an actual price reversal. With its long upper shadow, an inverted hammer signifies intra-session buying interest that faded by the finish. Even though the security finished well below its high, the ability of buyers to push prices higher during the session is bullish. The long white candlestick and white marubozu signify sustained buying pressure in which prices advanced sharply from open to close. Signs of increased buying pressure bode well for support.
The doji and spinning top denote indecision and are generally considered neutral. These non-reversal patterns indicate a decrease in selling pressure, but not necessarily a revival of buying pressure. After a decline, the appearance of a doji or spinning top denotes a sudden letup in selling pressure. A stand-off has developed between buyers and sellers, and a support level may form.
Note: All of the patterns above will be covered in this candlestick series in the next few weeks.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlesticks_and_support/candle5-suppdoji.png
Electronic Data Systems (EDS)http://stockcharts.com/images/minilink_sc.gif traded in a range bound by 58 and 75 for about 4 months at the beginning of 2000. Support at 58 was first established in early January and resistance at 75 in late January. The stock declined to its previous support level in early March, formed a long legged doji and later a spinning top (red circle). Notice that the doji formed immediately after a long black Marubozu (long black candlestick without upper or lower shadows). This doji marked a sudden decrease in relative selling pressure and support held. Support was tested again in April and this test was also marked by a long legged doji (blue arrow).
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlesticks_and_support/candle5-suppbulleng.png
Broadcom (BRCM)http://stockcharts.com/images/minilink_sc.gif formed a bullish engulfing pattern to mark a new support level just below 210 (green oval) in late July 2000. A few days later a long white candlestick formed and engulfed the previous 4 candlesticks. The combination of the bullish engulfing and long white candlestick served to reinforce the validity of support around 208. The stock has since tested support around 208 once in early September and twice in October. A piercing pattern (red arrow) formed in early October and a large hammer in late October.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlesticks_and_support/candle5-suppham.png
Medtronic (MDT)http://stockcharts.com/images/minilink_sc.gif established support around 46 in late February with a spinning top (red arrow) and early March with a harami. The stock declined sharply in April and formed a hammer to confirm support at 46 (green arrow). After a reaction rally to resistance around 57, the stock again declined sharply and again found support around 46 (blue arrow). The black candlestick with the long lower shadow marked support, but the body was too big to qualify as a hammer.
Additional ReadingYou may also be interested in our next article on Candlesticks and Resistance.
[*]Reference Tool: Candlestick Pattern Dictionary
Candlestick Pattern Dictionary[*]Abandoned Baby: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleAbandonedBaby.gif A rare reversal pattern characterized by a gap followed by a Doji, which is then followed by another gap in the opposite direction. The shadows on the Doji must completely gap below or above the shadows of the first and third day.[*]Dark Cloud Cover: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleDarkCloudCover.gif A bearish reversal pattern that continues the uptrend with a long white body. The next day opens at a new high then closes below the midpoint of the body of the first day.[*]Doji: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candlestickDoji.gif Doji form when a security's open and close are virtually equal. The length of the upper and lower shadows can vary, and the resulting candlestick looks like, either, a cross, inverted cross, or plus sign. Doji convey a sense of indecision or tug-of-war between buyers and sellers. Prices move above and below the opening level during the session, but close at or near the opening level.[*]Downside Tasuki Gap: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleDownsideTasukiGap.gif A continuation pattern with a long, black body followed by another black body that has gapped below the first one. The third day is white and opens within the body of the second day, then closes in the gap between the first two days, but does not close the gap.[*]Dragonfly Doji: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleDragonflyDoji.gif A Doji where the open and close price are at the high of the day. Like other Doji days, this one normally appears at market turning points.[*]Engulfing Pattern: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleBearishEngulfing.gif A reversal pattern that can be bearish or bullish, depending upon whether it appears at the end of an uptrend (bearish engulfing pattern) or a downtrend (bullish engulfing pattern). The first day is characterized by a small body, followed by a day whose body completely engulfs the previous day's body.[*]Evening Doji Star: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleEveningDojiStar.gif A three day bearish reversal pattern similar to the Evening Star. The uptrend continues with a large white body. The next day opens higher, trades in a small range, then closes at its open (Doji). The next day closes below the midpoint of the body of the first day.[*]Evening Star: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleEveningStar.gif A bearish reversal pattern that continues an uptrend with a long white body day followed by a gapped up small body day, then a down close with the close below the midpoint of the first day.[*]Falling Three Methods: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleFallingThreeMethods.gif A bearish continuation pattern. A long black body is followed by three small body days, each fully contained within the range of the high and low of the first day. The fifth day closes at a new low.[*]Gravestone Doji: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleGravestoneDoji.gif A doji line that develops when the Doji is at, or very near, the low of the day.[*]Hammer: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleHammer.gif Hammer candlesticks form when a security moves significantly lower after the open, but rallies to close well above the intraday low. The resulting candlestick looks like a square lollipop with a long stick. If this candlestick forms during an advance, then it is called a Hanging Man.[*]Hanging Man: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleHangingMan.gif Hanging Man candlesticks form when a security moves significantly lower after the open, but rallies to close well above the intraday low. The resulting candlestick looks like a square lollipop with a long stick. If this candlestick forms during a decline, then it is called a Hammer.[*]Harami: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleHarami.gif A two day pattern that has a small body day completely contained within the range of the previous body, and is the opposite color.[*]Harami Cross: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleHaramiCross.gif A two day pattern similar to the Harami. The difference is that the last day is a Doji.[*]Inverted Hammer: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleInvertedHammer.gif A one day bullish reversal pattern. In a downtrend, the open is lower, then it trades higher, but closes near its open, therefore looking like an inverted lollipop.[*]Long Day: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleLongDay.gif A long day represents a large price move from open to close, where the length of the candle body is long.[*]Long-Legged Doji: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleLongLeggedDoji.gif This candlestick has long upper and lower shadows with the Doji in the middle of the day's trading range, clearly reflecting the indecision of traders.[*]Long Shadows: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleLongShadows.gif Candlesticks with a long upper shadow and short lower shadow indicate that buyers dominated during the session and bid prices higher. Conversely, candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the session and drove prices lower.[*]Marubozo: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candle1-marubozu_001.gif A candlestick with no shadow extending from the body at either the open, the close or at both. The name means close-cropped or close-cut in Japanese, though other interpretations refer to it as Bald or Shaven Head.[*]Morning Doji Star: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleMorningDojiStar.gif A three day bullish reversal pattern that is very similar to the Morning Star. The first day is in a downtrend with a long black body. The next day opens lower with a Doji that has a small trading range. The last day closes above the midpoint of the first day.[*]Morning Star: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleMorningStar.gif A three day bullish reversal pattern consisting of three candlesticks - a long-bodied black candle extending the current downtrend, a short middle candle that gapped down on the open, and a long-bodied white candle that gapped up on the open and closed above the midpoint of the body of the first day.[*]Piercing Line: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candlePiercingLine.gif A bullish two day reversal pattern. The first day, in a downtrend, is a long black day. The next day opens at a new low, then closes above the midpoint of the body of the first day.[*]Rising Three Methods: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleRisingThreeMethods.gif A bullish continuation pattern in which a long white body is followed by three small body days, each fully contained within the range of the high and low of the first day. The fifth day closes at a new high.[*]Shooting Star: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleShootingStar.gif A single day pattern that can appear in an uptrend. It opens higher, trades much higher, then closes near its open. It looks just like the Inverted Hammer except that it is bearish.[*]Short Day: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleShortDay.gif A short day represents a small price move from open to close, where the length of the candle body is short.[*]Spinning Top: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleSpinningTops.gif Candlestick lines that have small bodies with upper and lower shadows that exceed the length of the body. Spinning tops signal indecision.[*]Stars: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleStars.gif A candlestick that gaps away from the previous candlestick is said to be in star position. Depending on the previous candlestick, the star position candlestick gaps up or down and appears isolated from previous price action.[*]Stick Sandwich: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleStickSandwich.gif A bullish reversal pattern with two black bodies surrounding a white body. The closing prices of the two black bodies must be equal. A support prices is apparent and the opportunity for prices to reverse is quite good.[*]Three Black Crows: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleThreeBlackCrows.gif A bearish reversal pattern consisting of three consecutive black bodies where each day closes near below the previous low and opens within the body of the previous day.[*]Three White Soldiers: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleThreeWhiteSoldiers.gif A bullish reversal pattern consisting of three consecutive white bodies, each with a higher close. Each should open within the previous body and the close should be near the high of the day.[*]Upside Gap Two Crows: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleUpsideGapTwoCrows.gif A three day bearish pattern that only happens in an uptrend. The first day is a long white body followed by a gapped open with the small black body remaining gapped above the first day. The third day is also a black day whose body is larger than the second day and engulfs it. The close of the last day is still above the first long white day.[*]Upside Tasuki Gap: http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_pattern_dictionary/candleUpsideTasukiGap.gif A continuation pattern with a long white body followed by another white body that has gapped above the first one. The third day is black and opens within the body of the second day, then closes in the gap between the first two days, but does not close the gap.
For information on candlestick history and interpretation, see the StockCharts Introduction to Candlesticks.
Additional Reading[*]Have you read our Introduction to Candlesticks?
Candlesticks and ResistanceSingle candlesticks and candlestick patterns can be used to confirm or mark resistance levels. Such a resistance level could be new after an extended advance, or an existing resistance level confirmed within a trading range. In a trading range, candlesticks can help identify entry points to sell near resistance or buy near support. The list below contains some, but not all, of the candlesticks and candlestick patterns that can be used to identify or confirm resistance levels. The bearish reversal patterns are marked (R).
Bearish Engulfing (R)
Bearish Harami (R)
Dark Cloud Cover (R)
Doji (Normal, Long Legged, Gravestone)
Evening Star or Bearish Abandoned Baby (R)
Hanging Man (R)
Long Black Candlestick or Black Marubozu
Shooting Star (R)
Spinning Top
[*]Three Black Crows (R)
Bearish reversal candlesticks and patterns suggest that buying pressure was suddenly overturned and selling pressure prevailed. Such a quick reversal of fortune indicates overhead supply and a resistance level may form.
The hanging man, long black candlestick and black marubozu signify increased selling pressure rather than an actual reversal. After an advance, the hanging man's long lower shadow indicates intra-session selling pressure that was overcome by the end of the session. Even though the security finished above its low, the ability of sellers to drive prices lower raises a yellow flag. The long black candlestick and black marubozu signify sustained selling pressure that moved prices significantly lower from beginning to end. Such intense selling pressure signals weakness among buyers and a resistance level may be established.
The doji and spinning top show indecision and are generally considered neutral. These non-reversal patterns indicate decreased buying pressure, but no noticeable increase in selling pressure. For an advance to continue, new buyers must be willing to pay higher prices. As noted by the spinning top and doji, a standoff shows lack of conviction among buyers and a possible resistance level.
Note: All of the above patterns will be covered in this candlestick series in the next week or two.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_and_resistance/candle6-resistdoji-vrts.png
In late May, Veritas (VRTS)http://stockcharts.com/images/minilink_sc.gif advanced from 90 to 140 in about two weeks. The final jump came with a gap up and two doji. These doji marked a sudden stalemate between buyers and sellers, and a resistance level subsequently formed. After a resistance test in mid June, another doji formed to indicate that buyers lacked conviction. This led to a decline and subsequent reaction rally in early July. The advance carried the stock from 105 to 140, where another doji formed to confirm resistance set in early June.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_and_resistance/candle6-resistdark-lu.png
Lucent (LU)http://stockcharts.com/images/minilink_sc.gif traded in a range bound by 53 and 42 for about 4 months. Resistance was first established in late April with a shooting star and dark cloud cover. Both of these bearish reversals were confirmed with a gap down two days later and a test of resistance at 52. As the stock neared support at 42, candlesticks with long lower shadow started to form and a reversal occurred at the end of May. After a sharp advance, resistance was met at and another dark cloud cover formed at resistance in early June. Buyers clearly lacked conviction near 53 and sellers were all too eager to unload their stock. A final resistance test occurred in mid July. After a breakout above 53, the stock reversed course and closed back below 52. The rest is history.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_and_resistance/candle6-resistshoot-dal.png
After a spring advance, Delta Air Lines (DAL)http://stockcharts.com/images/minilink_sc.gif first established resistance at 57 in early April with the high of a shooting star. The stock declined sharply, but rebounded to test resistance at 57 again in May. While at resistance in May, a whole slew of shooting stars formed as well as the odd spinning top and long legged doji. The decline that broke below 56 confirmed these as bearish and the stock tested support around 50. After another advance to 57, the stock appeared to be on the verge of a breakout. However, a small white candlestick formed in mid July (black circle). The gap up may have been a positive, but the lack of follow through signaled by the small white candlestick raised the yellow flag. The subsequent gap down formed a bearish evening star and the stock fell back to support again.
Additional ReadingHave you read our previous article on Candlesticks and Support?
You may also be interested in our next article on Candlestick Bullish Reversal Patterns.
[*]Reference Tool: Candlestick Pattern Dictionary
Candlestick Bullish Reversal PatternsThere are dozens of bullish reversal candlestick patterns. I have elected to narrow the field by selecting the most popular for detailed explanations. Below are some of the key bullish reversal patterns with the number of candlesticks required in parentheses.
Bullish Engulfing (2)
Piercing Pattern (2)
Bullish Harami (2)
Hammer (1)
Inverted Hammer (1)
Morning Star (3)
[*]Bullish Abandoned Baby (3)
The hammer and inverted hammer were covered in the article Introduction to Candlesticks. This article will focus on the other six patterns. For a complete list of bullish (and bearish) reversal patterns, see Greg Morris' book, Candlestick Charting Explained.
Before moving on to individual patterns, certain guidelines should be established:
Most patterns require bullish confirmation.
Bullish reversal patterns should form within a downtrend.
[*]Other aspects of technical analysis should be used as well.
Bullish ConfirmationPatterns can form with one or more candlesticks; most require bullish confirmation. The actual reversal indicates that buyers overcame prior selling pressure, but it remains unclear whether new buyers will bid prices higher. Without confirmation, these patterns would be considered neutral and merely indicate a potential support level at best. Bullish confirmation means further upside follow through and can come as a gap up, long white candlestick or high volume advance. Because candlestick patterns are short-term and usually effective for only 1 or 2 weeks, bullish confirmation should come within 1 to 3 days after the pattern.
Existing DowntrendTo be considered a bullish reversal, there should be an existing downtrend to reverse. A bullish engulfing at new highs can hardly be considered a bullish reversal pattern. Such formations would indicate continued buying pressure and could be considered a continuation pattern. In the Ciena example below, the pattern in the red oval looks like a bullish engulfing, but formed near resistance after about a 30 point advance. The pattern does show strength, but is more likely a continuation at this point than a reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev-bulleng-cien.png
The existence of a downtrend can be determined by using moving averages, peak/trough analysis or trend lines. A security could be deemed in a downtrend based on one of the following:
The security is trading below its 20-day exponential moving average (EMA).
Each reaction peak and trough is lower than the previous.
[*]The security is trading below its trend line.
These are just examples of possible guidelines to determine a downtrend. Some traders may prefer shorter downtrends and consider securities below the 10-day EMA. Defining criteria will depend on your trading style and personal preferences.
Other Technical AnalysisCandlesticks provide an excellent means to identify short-term reversals, but should not be used alone. Other aspects of technical analysis can and should be incorporated to increase reversal robustness. Below are three ideas on how traditional technical analysis might be combined with candlestick analysis.
SupportLook for bullish reversals at support levels to increase robustness. Support levels can be identified with moving averages, previous reaction lows, trend lines or Fibonacci retracements.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev-50corr-jnpr.png
MomentumUse oscillators to confirm improving momentum with bullish reversals. Positive divergences in MACD, PPO, Stochastics, RSI, StochRSI or Williams %R would indicate improving momentum and increase the robustness behind a bullish reversal pattern.
Money FlowsMoney Flows: Use volume-based indicators to access buying and selling pressure. On Balance Volume (OBV), Chaikin Money Flow (CMF) and the Accumulation/Distribution Line can be used in conjunction with candlesticks. Strength in any of these would increase the robustness of a reversal.
For those that want to take it one step further, all three aspects could be combined for the ultimate signal. Look for bullish candlestick reversal in securities trading near support with positive divergences and signs of buying pressure.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev-otherta-ibm.png
A number of signals came together for IBMhttp://stockcharts.com/images/minilink_sc.gif in early October. After a steep decline since August, the stock formed a bullish engulfing pattern (red oval) and this was confirmed three days later with a strong advance. The 10-day Slow Stochastic Oscillator formed a positive divergence and moved above its trigger line just before the stock advanced. Although not in the green yet, CMF showed constant improvement and moved into positive territory a week later.
Bullish EngulfingThe bullish engulfing pattern consists of two candlesticks, the first black and the second white. The size of the black candlestick is not that important, but it should not be a doji which would be relatively easy to engulf. The second should be a long white candlestick – the bigger it is, the more bullish. The white body must totally engulf the body of the first black candlestick. Ideally, though not necessarily, the white body would engulf the shadows as well. Although shadows are permitted, they are usually small or nonexistent on both candlesticks.
After a decline, the second white candlestick begins to form when selling pressure causes the security to open below the previous close. Buyers step in after the open and push prices above the previous open for a strong finish and potential short-term reversal. Generally, the larger the white candlestick and the greater the engulfing, the more bullish the reversal. Further strength is required to provide bullish confirmation of this reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-bulleng-sunw.png
In Jan-00, Sun Microsystems (SUNW)http://stockcharts.com/images/minilink_sc.gif formed a pair of bullish engulfing patterns that foreshadowed two significant advances. The first formed in early January after a sharp decline that took the stock well below its 20-day exponential moving average (EMA). An immediate gap up confirmed the pattern as bullish and the stock raced ahead to the mid-forties. After correcting to support, the second bullish engulfing pattern formed in late January. The stock declined below its 20-day EMA and found support from its earlier gap up. This also marked a 2/3 correction of the prior advance. A bullish engulfing pattern formed and was confirmed the next day with a strong follow-up advance.
Piercing PatternThe piercing pattern is made up of two candlesticks, the first black and the second white. Both candlesticks should have fairly large bodies and the shadows are usually, but not necessarily, small or nonexistent. The white candlestick must open below the previous close and close above the midpoint of the black candlestick's body. A close below the midpoint might qualify as a reversal, but would not be considered as bullish.
Just as with the bullish engulfing pattern, selling pressure forces the security to open below the previous close, indicating that sellers still have the upper hand on the open. However, buyers step in after the open to push the security higher and it closes above the midpoint of the previous black candlestick's body. Further strength is required to provide bullish confirmation of this reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-piercing-cien.png
In late March and early April 2000, Ciena (CIEN)http://stockcharts.com/images/minilink_sc.gif declined from above 80 to around 40. The stock first touched 40 in early April with a long lower shadow. After a bounce, the stock tested support around 40 again in mid April and formed a piercing pattern. The piercing pattern was confirmed the very next day with a strong advance above 50. Even though there was a setback after confirmation, the stock remained above support and advanced above 70. Also notice the morning doji star in late May.
Bullish HaramiThe bullish harami is made up of two candlesticks. The first has a large body and the second a small body that is totally encompassed by the first. There are four possible combinations: white/white, white/black, black/white and black/black. Whether they are bullish reversal or bearish reversal patterns, all harami look the same. Their bullish or bearish nature depends on the preceding trend. Harami are considered potential bullish reversals after a decline and potential bearish reversals after an advance. No matter what the color of the first candlestick, the smaller the body of the second candlestick is, the more likely the reversal. If the small candlestick is a doji, the chances of a reversal increase.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-haramis.gif
In his book Beyond Candlesticks, Steve Nison asserts that any combination of colors can form a harami, but that the most bullish are those that form with a white/black or white/white combination. Because the first candlestick has a large body, it implies that the bullish reversal pattern would be stronger if this body were white. The long white candlestick shows a sudden and sustained resurgence of buying pressure. The small candlestick afterwards indicates consolidation. White/white and white/black bullish harami are likely to occur less often than black/black or black/white.
After a decline, a black/black or black/white combination can still be regarded as a bullish harami. The first long black candlestick signals that significant selling pressure remains and could indicate capitulation. The small candlestick immediately following forms with a gap up on the open, indicating a sudden increase in buying pressure and potential reversal.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-harami-muse.png
Micromuse (MUSE)http://stockcharts.com/images/minilink_sc.gif declined to the mid sixties in Apr-00 and began to trade in a range bound by 33 and 50 over the next few weeks. After a 6-day decline back to support in late May, a bullish harami (red oval) formed. The first day formed a long white candlestick, and the second a small black candlestick that could be classified as a doji. The next day's advance provided bullish confirmation and the stock subsequently rose to around 75.
HammerThe hammer is made up of one candlestick, white or black, with a small body, long lower shadow and small or nonexistent upper shadow. The size of the lower shadow should be a least twice the length of the body and the high/low range should be relatively large. Large is a relative term and the high/low range should be large relative to range over the last 10-20 days.
After a decline, the hammer's intraday low indicates that selling pressure remains. However, the strong close shows that buyers are starting to become active again. Further strength is required to provide bullish confirmation of this reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-hammer-nke.png
Nike (NKE)http://stockcharts.com/images/minilink_sc.gif declined from the low fifties to the mid thirties before starting to find support in late February. After a small reaction rally, the stock declined back to support in mid March and formed a hammer. Bullish confirmation came two days later with a sharp advance.
Morning StarThe morning star consists of three candlesticks:
A long black candlestick.
A small white or black candlestick that gaps below the close of the previous candlestick. This candlestick can also be a doji, in which case the pattern would be a morning doji star.
[*]A long white candlestick.
The black candlestick confirms that the decline remains in force and selling dominates. When the second candlestick gaps down, it provides further evidence of selling pressure. However, the decline ceases or slows significantly after the gap and a small candlestick forms. The small candlestick indicates indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase. The third long white candlestick provides bullish confirmation of the reversal.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-mornstar-brcm.png
After declining from above 180 to below 120, Broadcom (BRCM)http://stockcharts.com/images/minilink_sc.gif formed a morning doji star and subsequently advanced above 160 in the next three days. These are strong reversal patterns and do not require further bullish confirmation, beyond the long white candlestick on the third day. After the advance above 160, a two-week pullback followed and the stock formed a piecing pattern (red arrow) that was confirmed with a large gap up.
Bullish Abandoned BabyThe bullish abandoned baby resembles the morning doji star and also consists of three candlesticks:
A long black candlestick.
A doji that gaps below the low of the previous candlestick.
[*]A long white candlestick that gaps above the high of the doji.
The main difference between the morning doji star and the bullish abandoned baby are the gaps on either side of the doji. The first gap down signals that selling pressure remains strong. However, selling pressure eases and the security closes at or near the open, creating a doji. Following the doji, the gap up and long white candlestick indicate strong buying pressure and the reversal is complete. Further bullish confirmation is not required.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-abandon-genz.png
In April, Genzyme (GENZ)http://stockcharts.com/images/minilink_sc.gif declined below its 20-day EMA and began to find support in the low thirties. The stock began forming a base as early as 17-Apr, but a discernible reversal pattern failed to emerge until the end of May. The bullish abandoned baby formed with a long black candlestick, doji and long white candlestick. The gaps on either side of the doji reinforced the bullish reversal.
Bullish ConfirmationPatterns can form with one or more candlesticks; most require bullish confirmation. The actual reversal indicates that buyers overcame prior selling pressure, but it remains unclear whether new buyers will bid prices higher. Without confirmation, these patterns would be considered neutral and merely indicate a potential support level at best. Bullish confirmation means further upside follow through and can come as a gap up, long white candlestick or high volume advance. Because candlestick patterns are short-term and usually effective for only 1 or 2 weeks, bullish confirmation should come within 1 to 3 days after the pattern.
Existing DowntrendTo be considered a bullish reversal, there should be an existing downtrend to reverse. A bullish engulfing at new highs can hardly be considered a bullish reversal pattern. Such formations would indicate continued buying pressure and could be considered a continuation pattern. In the Ciena example below, the pattern in the red oval looks like a bullish engulfing, but formed near resistance after about a 30 point advance. The pattern does show strength, but is more likely a continuation at this point than a reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev-bulleng-cien.png
The existence of a downtrend can be determined by using moving averages, peak/trough analysis or trend lines. A security could be deemed in a downtrend based on one of the following:
The security is trading below its 20-day exponential moving average (EMA).
Each reaction peak and trough is lower than the previous.
[*]The security is trading below its trend line.
These are just examples of possible guidelines to determine a downtrend. Some traders may prefer shorter downtrends and consider securities below the 10-day EMA. Defining criteria will depend on your trading style and personal preferences.
Other Technical AnalysisCandlesticks provide an excellent means to identify short-term reversals, but should not be used alone. Other aspects of technical analysis can and should be incorporated to increase reversal robustness. Below are three ideas on how traditional technical analysis might be combined with candlestick analysis.
SupportLook for bullish reversals at support levels to increase robustness. Support levels can be identified with moving averages, previous reaction lows, trend lines or Fibonacci retracements.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev-50corr-jnpr.png
MomentumUse oscillators to confirm improving momentum with bullish reversals. Positive divergences in MACD, PPO, Stochastics, RSI, StochRSI or Williams %R would indicate improving momentum and increase the robustness behind a bullish reversal pattern.
Money FlowsMoney Flows: Use volume-based indicators to access buying and selling pressure. On Balance Volume (OBV), Chaikin Money Flow (CMF) and the Accumulation/Distribution Line can be used in conjunction with candlesticks. Strength in any of these would increase the robustness of a reversal.
For those that want to take it one step further, all three aspects could be combined for the ultimate signal. Look for bullish candlestick reversal in securities trading near support with positive divergences and signs of buying pressure.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev-otherta-ibm.png
A number of signals came together for IBMhttp://stockcharts.com/images/minilink_sc.gif in early October. After a steep decline since August, the stock formed a bullish engulfing pattern (red oval) and this was confirmed three days later with a strong advance. The 10-day Slow Stochastic Oscillator formed a positive divergence and moved above its trigger line just before the stock advanced. Although not in the green yet, CMF showed constant improvement and moved into positive territory a week later.
Bullish EngulfingThe bullish engulfing pattern consists of two candlesticks, the first black and the second white. The size of the black candlestick is not that important, but it should not be a doji which would be relatively easy to engulf. The second should be a long white candlestick – the bigger it is, the more bullish. The white body must totally engulf the body of the first black candlestick. Ideally, though not necessarily, the white body would engulf the shadows as well. Although shadows are permitted, they are usually small or nonexistent on both candlesticks.
After a decline, the second white candlestick begins to form when selling pressure causes the security to open below the previous close. Buyers step in after the open and push prices above the previous open for a strong finish and potential short-term reversal. Generally, the larger the white candlestick and the greater the engulfing, the more bullish the reversal. Further strength is required to provide bullish confirmation of this reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-bulleng-sunw.png
In Jan-00, Sun Microsystems (SUNW)http://stockcharts.com/images/minilink_sc.gif formed a pair of bullish engulfing patterns that foreshadowed two significant advances. The first formed in early January after a sharp decline that took the stock well below its 20-day exponential moving average (EMA). An immediate gap up confirmed the pattern as bullish and the stock raced ahead to the mid-forties. After correcting to support, the second bullish engulfing pattern formed in late January. The stock declined below its 20-day EMA and found support from its earlier gap up. This also marked a 2/3 correction of the prior advance. A bullish engulfing pattern formed and was confirmed the next day with a strong follow-up advance.
Piercing PatternThe piercing pattern is made up of two candlesticks, the first black and the second white. Both candlesticks should have fairly large bodies and the shadows are usually, but not necessarily, small or nonexistent. The white candlestick must open below the previous close and close above the midpoint of the black candlestick's body. A close below the midpoint might qualify as a reversal, but would not be considered as bullish.
Just as with the bullish engulfing pattern, selling pressure forces the security to open below the previous close, indicating that sellers still have the upper hand on the open. However, buyers step in after the open to push the security higher and it closes above the midpoint of the previous black candlestick's body. Further strength is required to provide bullish confirmation of this reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-piercing-cien.png
In late March and early April 2000, Ciena (CIEN)http://stockcharts.com/images/minilink_sc.gif declined from above 80 to around 40. The stock first touched 40 in early April with a long lower shadow. After a bounce, the stock tested support around 40 again in mid April and formed a piercing pattern. The piercing pattern was confirmed the very next day with a strong advance above 50. Even though there was a setback after confirmation, the stock remained above support and advanced above 70. Also notice the morning doji star in late May.
Bullish HaramiThe bullish harami is made up of two candlesticks. The first has a large body and the second a small body that is totally encompassed by the first. There are four possible combinations: white/white, white/black, black/white and black/black. Whether they are bullish reversal or bearish reversal patterns, all harami look the same. Their bullish or bearish nature depends on the preceding trend. Harami are considered potential bullish reversals after a decline and potential bearish reversals after an advance. No matter what the color of the first candlestick, the smaller the body of the second candlestick is, the more likely the reversal. If the small candlestick is a doji, the chances of a reversal increase.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-haramis.gif
In his book Beyond Candlesticks, Steve Nison asserts that any combination of colors can form a harami, but that the most bullish are those that form with a white/black or white/white combination. Because the first candlestick has a large body, it implies that the bullish reversal pattern would be stronger if this body were white. The long white candlestick shows a sudden and sustained resurgence of buying pressure. The small candlestick afterwards indicates consolidation. White/white and white/black bullish harami are likely to occur less often than black/black or black/white.
After a decline, a black/black or black/white combination can still be regarded as a bullish harami. The first long black candlestick signals that significant selling pressure remains and could indicate capitulation. The small candlestick immediately following forms with a gap up on the open, indicating a sudden increase in buying pressure and potential reversal.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-harami-muse.png
Micromuse (MUSE)http://stockcharts.com/images/minilink_sc.gif declined to the mid sixties in Apr-00 and began to trade in a range bound by 33 and 50 over the next few weeks. After a 6-day decline back to support in late May, a bullish harami (red oval) formed. The first day formed a long white candlestick, and the second a small black candlestick that could be classified as a doji. The next day's advance provided bullish confirmation and the stock subsequently rose to around 75.
HammerThe hammer is made up of one candlestick, white or black, with a small body, long lower shadow and small or nonexistent upper shadow. The size of the lower shadow should be a least twice the length of the body and the high/low range should be relatively large. Large is a relative term and the high/low range should be large relative to range over the last 10-20 days.
After a decline, the hammer's intraday low indicates that selling pressure remains. However, the strong close shows that buyers are starting to become active again. Further strength is required to provide bullish confirmation of this reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-hammer-nke.png
Nike (NKE)http://stockcharts.com/images/minilink_sc.gif declined from the low fifties to the mid thirties before starting to find support in late February. After a small reaction rally, the stock declined back to support in mid March and formed a hammer. Bullish confirmation came two days later with a sharp advance.
Morning StarThe morning star consists of three candlesticks:
A long black candlestick.
A small white or black candlestick that gaps below the close of the previous candlestick. This candlestick can also be a doji, in which case the pattern would be a morning doji star.
[*]A long white candlestick.
The black candlestick confirms that the decline remains in force and selling dominates. When the second candlestick gaps down, it provides further evidence of selling pressure. However, the decline ceases or slows significantly after the gap and a small candlestick forms. The small candlestick indicates indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase. The third long white candlestick provides bullish confirmation of the reversal.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-mornstar-brcm.png
After declining from above 180 to below 120, Broadcom (BRCM)http://stockcharts.com/images/minilink_sc.gif formed a morning doji star and subsequently advanced above 160 in the next three days. These are strong reversal patterns and do not require further bullish confirmation, beyond the long white candlestick on the third day. After the advance above 160, a two-week pullback followed and the stock formed a piecing pattern (red arrow) that was confirmed with a large gap up.
Bullish Abandoned BabyThe bullish abandoned baby resembles the morning doji star and also consists of three candlesticks:
A long black candlestick.
A doji that gaps below the low of the previous candlestick.
[*]A long white candlestick that gaps above the high of the doji.
The main difference between the morning doji star and the bullish abandoned baby are the gaps on either side of the doji. The first gap down signals that selling pressure remains strong. However, selling pressure eases and the security closes at or near the open, creating a doji. Following the doji, the gap up and long white candlestick indicate strong buying pressure and the reversal is complete. Further bullish confirmation is not required.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bullish_reversal_patterns/bullrev2-abandon-genz.png
In April, Genzyme (GENZ)http://stockcharts.com/images/minilink_sc.gif declined below its 20-day EMA and began to find support in the low thirties. The stock began forming a base as early as 17-Apr, but a discernible reversal pattern failed to emerge until the end of May. The bullish abandoned baby formed with a long black candlestick, doji and long white candlestick. The gaps on either side of the doji reinforced the bullish reversal.
Bearish ConfirmationBearish reversal patterns can form with one or more candlesticks; most require bearish confirmation. The actual reversal indicates that selling pressure overwhelmed buying pressure for one or more days, but it remains unclear whether or not sustained selling or lack of buyers will continue to push prices lower. Without confirmation, many of these patterns would be considered neutral and merely indicate a potential resistance level at best. Bearish confirmation means further downside follow through, such as a gap down, long black candlestick or high volume decline. Because candlestick patterns are short-term and usually effective for 1-2 weeks, bearish confirmation should come within 1-3 days.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev1-aol-darkconfirm.png
Time Warner (TWX)http://stockcharts.com/images/minilink_sc.gif advanced from the upper fifties to the low seventies in less than two months. The long white candlestick that took the stock above 70 in late March was followed by a long-legged doji in the harami position. A second long-legged doji immediately followed and indicated that the uptrend was beginning to tire. The dark cloud cover (red oval) increased these suspicions and bearish confirmation was provided by the long black candlestick (red arrow).
Existing UptrendTo be considered a bearish reversal, there should be an existing uptrend to reverse. It does not have to be a major uptrend, but should be up for the short term or at least over the last few days. A dark cloud cover after a sharp decline or near new lows is unlikely to be a valid bearish reversal pattern. Bearish reversal patterns within a downtrend would simply confirm existing selling pressure and could be considered continuation patterns.
There are many methods available to determine the trend. An uptrend can be established using moving averages, peak/trough analysis or trend lines. A security could be deemed in an uptrend based on one or more of the following:
The security is trading above its 20-day exponential moving average (EMA).
Each reaction peak and trough is higher than the previous.
[*]The security is trading above a trend line.
These are just three possible methods. Some traders may prefer shorter uptrends and qualify securities that are trading above their 10-day EMA. Defining criteria will depend on your trading style, time horizon and personal preferences.
Other Technical AnalysisCandlesticks provide an excellent means to identify short-term reversals, but should not be used alone. Other aspects of technical analysis can and should be incorporated to increase the robustness of bearish reversal patterns.
Resistancehttp://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev1-nke-bearengresist.png
In Jan-00, Nike (NKE)http://stockcharts.com/images/minilink_sc.gif gapped up over 5 points and closed above 50. A candlestick with a long upper shadow formed and the stock subsequently traded down to 45. This established a resistance level around 53. After an advance back to resistance at 53, the stock formed a bearish engulfing pattern (red oval). Bearish confirmation came when the stock declined the next day, gapped down below 50 and broke its short-term trend line two days later.
MomentumUse oscillators to confirm weakening momentum with bearish reversals. Negative divergences in MACD, PPO, Stochastics, RSI, StochRSI or Williams %R indicate weakening momentum and can increase the robustness of a bearish reversal pattern. In addition, bearish moving average crossovers in the PPO and MACD can provide confirmation, as well as trigger line crossovers for the Slow Stochastic Oscillator.
Money FlowsUse volume-based indicators to assess selling pressure and confirm reversals. On Balance Volume (OBV), Chaikin Money Flow and the Accumulation/Distribution Line can be used to spot negative divergences or simply excessive selling pressure. Signs of increased selling pressure can improve the robustness of a bearish reversal pattern.
For those that want to take it one step further, all three aspects could be combined for the ultimate signal. Look for a bearish candlestick reversal in securities trading near resistance with weakening momentum and signs of increased selling pressure. Such signals would be relatively rare, but could offer above-average profit potential.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev1-rsh-darkta.png
A number of signals came together for RadioShack (RSH)http://stockcharts.com/images/minilink_sc.gif in early Oct-00. The stock traded up to resistance at 70 for the third time in two months and formed a dark cloud cover pattern (red oval). In addition, the long black candlestick had a long upper shadow to indicate an intraday reversal. Bearish confirmation came the next day with a sharp decline. The negative divergence in the PPO and extremely weak money flows also provided further bearish confirmation.
Bearish EngulfingThe bearish engulfing pattern consists of two candlesticks; the first is white and the second black. The size of the white candlestick is not that important, but should not be a doji, which would be relatively easy to engulf. The second should be a long black candlestick. The bigger it is, the more bearish the reversal. The black body must totally engulf the body of the first, white, candlestick. Ideally, the black body should engulf the shadows as well, but this is not a requirement. Shadows are permitted, but they are usually small or nonexistent on both candlesticks.
After an advance, the second black candlestick begins to form when residual buying pressure causes the security to open above the previous close. However, sellers step in after this opening gap up and begin to drive prices down. By the end of the session, selling becomes so intense that prices move below the previous open. The resulting candlestick engulfs the previous day's body and creates a potential short-term reversal. Further weakness is required for bearish confirmation of this reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-beareng-f.png
After meeting resistance around 30 in mid-January, Ford (F)http://stockcharts.com/images/minilink_sc.gif formed a bearish engulfing (red oval). The pattern was immediately confirmed with a decline and subsequent support break.
Dark Cloud CoverThe dark cloud cover pattern is made up of two candlesticks; the first is white and the second black. Both candlesticks should have fairly large bodies and the shadows are usually small or nonexistent, though not necessarily. The black candlestick must open above the previous close and close below the midpoint of the white candlestick's body. A close above the midpoint might qualify as a reversal, but would not be considered as bearish.
Just as with the bearish engulfing pattern, residual buying pressure forces prices higher on the open, creating an opening gap above the white candlestick's body. However, sellers step in after the strong open and push prices lower. The intensity of the selling drives prices below the midpoint of the white candlestick's body. Further weakness is required for bearish confirmation of this reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-darkcloud-c.png
After a sharp advance from 37 1/2 to 40.5 in about 2 weeks, Citigroup (C)http://stockcharts.com/images/minilink_sc.gif formed a dark cloud cover pattern (red oval). This pattern was confirmed with two long black candlesticks and marked an abrupt reversal around 40.5.
Shooting StarThe shooting star is made up of one candlestick (white or black) with a small body, long upper shadow and small or nonexistent lower shadow. The size of the upper shadow should be a least twice the length of the body and the high/low range should be relatively large. Large is a relative term and the high/low range should be large relative to the range over the last 10-20 days.
For a candlestick to be in star position, it must gap way from the previous candlestick. In Candlestick Charting Explained, Greg Morris indicates that a shooting star should gap up from the preceding candlestick. However, in Beyond Candlesticks, Steve Nison provides a shooting star example that forms below the previous close. There should be room to maneuver, especially when dealing with stocks and indices, which often open near the previous close. A gap up would definitely enhance the robustness of a shooting star, but the essence of the reversal should not be lost without the gap.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-shoot-chv.png
After an advance that was punctuated by a long white candlestick, Chevron (CHV)http://stockcharts.com/images/minilink_sc.gif formed a shooting star candlestick above 90 (red oval). The bearish reversal pattern was confirmed with a gap down the following day
Bearish HaramiThe bearish harami is made up of two candlesticks. The first has a large body and the second a small body that is totally encompassed by the first. There are four possible combinations: white/white, white/black, black/white and black/black. Whether a bullish reversal or bearish reversal pattern, all harami look the same. Their bullish or bearish nature depends on the preceding trend. Harami are considered potential bearish reversals after an advance and potential bullish reversals after a decline. No matter what the color of the first candlestick, the smaller the body of the second candlestick is, the more likely the reversal. If the small candlestick is a doji, the chances of a reversal increase.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bullrev2-haramis.gif
In his book, Beyond Candlesticks, Steve Nison asserts that any combination of colors can form a harami, but the most bearish are those that form with a black/white or black/black combination. Because the first candlestick has a large body, it implies that the bearish reversal pattern would be stronger if this body were black. This would indicate a sudden and sustained increase in selling pressure. The small candlestick afterwards indicates consolidation before continuation. After an advance, black/white or black/black bearish harami are not as common as white/black or white/white variations.
A white/black or white/white combination can still be regarded as a bearish harami and signal a potential reversal. The first long white candlestick forms in the direction of the trend. It signals that significant buying pressure remains, but could also indicate excessive bullishness. Immediately following, the small candlestick forms with a gap down on the open, indicating a sudden shift towards the sellers and a potential reversal.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-bearhar-amtd.png
After a gap up and rapid advance to 30, Ameritrade (AMTD)http://stockcharts.com/images/minilink_sc.gif formed a bearish harami (red oval). This harami consists of a long black candlestick and a small black candlestick. The decline two days later confirmed the bearish harami and the stock fell to the low twenties.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-bearhar-mrk.png
Merck (MRK)http://stockcharts.com/images/minilink_sc.gif formed a bearish harami with a long white candlestick and long black candlestick (red oval). The long white candlestick confirmed the direction of the current trend. However, the stock gapped down the next day and traded in a narrow range. The decline three days later confirmed the pattern as bearish.
Evening StarThe evening star consists of three candlesticks:
A long white candlestick.
A small white or black candlestick that gaps above the close (body) of the previous candlestick. This candlestick can also be a doji, in which case the pattern would be a evening doji star.
[*]A long black candlestick.
The long white candlestick confirms that buying pressure remains strong and the trend is up. When the second candlestick gaps up, it provides further evidence of residual buying pressure. However, the advance ceases or slows significantly after the gap and a small candlestick forms, indicating indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase. The third long black candlestick provides bearish confirmation of the reversal.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-evestar-t.png
After advancing from 68 to 91 in about two weeks, AT&T (T)http://stockcharts.com/images/minilink_sc.gif formed an evening star (red oval). The middle candlestick is a spinning top, which indicates indecision and possible reversal. The gap above 91 was reversed immediately with a long black candlestick. Even though the stock stabilized in the next few days, it never exceeded the top of the long black candlestick and subsequently fell below 75.
Bearish Abandoned BabyThe bearish abandoned baby resembles the evening doji star and also consists of three candlesticks:
A long white candlestick.
A doji that gaps above the high of the previous candlestick.
[*]A long black candlestick that gaps below the low of the doji.
The main difference between the evening doji star and the bearish abandoned baby are the gaps on either side of the doji. The first gap up signals a continuation of the uptrend and confirms strong buying pressure. However, buying pressure subsides after the gap up and the security closes at or near the open, creating a doji. Following the doji, the gap down and long black candlestick indicate strong and sustained selling pressure to complete the reversal. Further bearish confirmation is not required.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-abandon-dal.png
Delta (DAL)http://stockcharts.com/images/minilink_sc.gif formed an abandoned baby to mark a sharp reversal that carried the stock from 57 1/2 to 47 1/2. Although the open and close are not exactly equal, the small white candlestick in the middle captures the essence of a doji. Indecision is reflected with the small body and equal upper and lower shadows. In addition, the middle candlestick is separated by gaps on either side, which add emphasis to the reversal.
Bearish ConfirmationBearish reversal patterns can form with one or more candlesticks; most require bearish confirmation. The actual reversal indicates that selling pressure overwhelmed buying pressure for one or more days, but it remains unclear whether or not sustained selling or lack of buyers will continue to push prices lower. Without confirmation, many of these patterns would be considered neutral and merely indicate a potential resistance level at best. Bearish confirmation means further downside follow through, such as a gap down, long black candlestick or high volume decline. Because candlestick patterns are short-term and usually effective for 1-2 weeks, bearish confirmation should come within 1-3 days.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev1-aol-darkconfirm.png
Time Warner (TWX)http://stockcharts.com/images/minilink_sc.gif advanced from the upper fifties to the low seventies in less than two months. The long white candlestick that took the stock above 70 in late March was followed by a long-legged doji in the harami position. A second long-legged doji immediately followed and indicated that the uptrend was beginning to tire. The dark cloud cover (red oval) increased these suspicions and bearish confirmation was provided by the long black candlestick (red arrow).
Existing UptrendTo be considered a bearish reversal, there should be an existing uptrend to reverse. It does not have to be a major uptrend, but should be up for the short term or at least over the last few days. A dark cloud cover after a sharp decline or near new lows is unlikely to be a valid bearish reversal pattern. Bearish reversal patterns within a downtrend would simply confirm existing selling pressure and could be considered continuation patterns.
There are many methods available to determine the trend. An uptrend can be established using moving averages, peak/trough analysis or trend lines. A security could be deemed in an uptrend based on one or more of the following:
The security is trading above its 20-day exponential moving average (EMA).
Each reaction peak and trough is higher than the previous.
[*]The security is trading above a trend line.These are just three possible methods. Some traders may prefer shorter uptrends and qualify securities that are trading above their 10-day EMA. Defining criteria will depend on your trading style, time horizon and personal preferences.
Other Technical AnalysisCandlesticks provide an excellent means to identify short-term reversals, but should not be used alone. Other aspects of technical analysis can and should be incorporated to increase the robustness of bearish reversal patterns.
Resistancehttp://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev1-nke-bearengresist.png
In Jan-00, Nike (NKE)http://stockcharts.com/images/minilink_sc.gif gapped up over 5 points and closed above 50. A candlestick with a long upper shadow formed and the stock subsequently traded down to 45. This established a resistance level around 53. After an advance back to resistance at 53, the stock formed a bearish engulfing pattern (red oval). Bearish confirmation came when the stock declined the next day, gapped down below 50 and broke its short-term trend line two days later.
MomentumUse oscillators to confirm weakening momentum with bearish reversals. Negative divergences in MACD, PPO, Stochastics, RSI, StochRSI or Williams %R indicate weakening momentum and can increase the robustness of a bearish reversal pattern. In addition, bearish moving average crossovers in the PPO and MACD can provide confirmation, as well as trigger line crossovers for the Slow Stochastic Oscillator.
Money FlowsUse volume-based indicators to assess selling pressure and confirm reversals. On Balance Volume (OBV), Chaikin Money Flow and the Accumulation/Distribution Line can be used to spot negative divergences or simply excessive selling pressure. Signs of increased selling pressure can improve the robustness of a bearish reversal pattern.
For those that want to take it one step further, all three aspects could be combined for the ultimate signal. Look for a bearish candlestick reversal in securities trading near resistance with weakening momentum and signs of increased selling pressure. Such signals would be relatively rare, but could offer above-average profit potential.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev1-rsh-darkta.png
A number of signals came together for RadioShack (RSH)http://stockcharts.com/images/minilink_sc.gif in early Oct-00. The stock traded up to resistance at 70 for the third time in two months and formed a dark cloud cover pattern (red oval). In addition, the long black candlestick had a long upper shadow to indicate an intraday reversal. Bearish confirmation came the next day with a sharp decline. The negative divergence in the PPO and extremely weak money flows also provided further bearish confirmation.
Bearish EngulfingThe bearish engulfing pattern consists of two candlesticks; the first is white and the second black. The size of the white candlestick is not that important, but should not be a doji, which would be relatively easy to engulf. The second should be a long black candlestick. The bigger it is, the more bearish the reversal. The black body must totally engulf the body of the first, white, candlestick. Ideally, the black body should engulf the shadows as well, but this is not a requirement. Shadows are permitted, but they are usually small or nonexistent on both candlesticks.
After an advance, the second black candlestick begins to form when residual buying pressure causes the security to open above the previous close. However, sellers step in after this opening gap up and begin to drive prices down. By the end of the session, selling becomes so intense that prices move below the previous open. The resulting candlestick engulfs the previous day's body and creates a potential short-term reversal. Further weakness is required for bearish confirmation of this reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-beareng-f.png
After meeting resistance around 30 in mid-January, Ford (F)http://stockcharts.com/images/minilink_sc.gif formed a bearish engulfing (red oval). The pattern was immediately confirmed with a decline and subsequent support break.
Dark Cloud CoverThe dark cloud cover pattern is made up of two candlesticks; the first is white and the second black. Both candlesticks should have fairly large bodies and the shadows are usually small or nonexistent, though not necessarily. The black candlestick must open above the previous close and close below the midpoint of the white candlestick's body. A close above the midpoint might qualify as a reversal, but would not be considered as bearish.
Just as with the bearish engulfing pattern, residual buying pressure forces prices higher on the open, creating an opening gap above the white candlestick's body. However, sellers step in after the strong open and push prices lower. The intensity of the selling drives prices below the midpoint of the white candlestick's body. Further weakness is required for bearish confirmation of this reversal pattern.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-darkcloud-c.png
After a sharp advance from 37 1/2 to 40.5 in about 2 weeks, Citigroup (C)http://stockcharts.com/images/minilink_sc.gif formed a dark cloud cover pattern (red oval). This pattern was confirmed with two long black candlesticks and marked an abrupt reversal around 40.5.
Shooting StarThe shooting star is made up of one candlestick (white or black) with a small body, long upper shadow and small or nonexistent lower shadow. The size of the upper shadow should be a least twice the length of the body and the high/low range should be relatively large. Large is a relative term and the high/low range should be large relative to the range over the last 10-20 days.
For a candlestick to be in star position, it must gap way from the previous candlestick. InGreg Morris indicates that a shooting star shouldfrom the preceding candlestick. However, inSteve Nison provides a shooting star example that forms below the previous close. There should be room to maneuver, especially when dealing with stocks and indices, which often open near the previous close. A gap up would definitely enhance the robustness of a shooting star, but the essence of the reversal should not be lost without the gap.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-shoot-chv.png
After an advance that was punctuated by a long white candlestick, Chevron (CHV)http://stockcharts.com/images/minilink_sc.gif formed a shooting star candlestick above 90 (red oval). The bearish reversal pattern was confirmed with a gap down the following day
Bearish HaramiThe bearish harami is made up of two candlesticks. The first has a large body and the second a small body that is totally encompassed by the first. There are four possible combinations: white/white, white/black, black/white and black/black. Whether a bullish reversal or bearish reversal pattern, all harami look the same. Their bullish or bearish nature depends on the preceding trend. Harami are considered potential bearish reversals after an advance and potential bullish reversals after a decline. No matter what the color of the first candlestick, the smaller the body of the second candlestick is, the more likely the reversal. If the small candlestick is a doji, the chances of a reversal increase.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bullrev2-haramis.gif
In his book, Beyond Candlesticks, Steve Nison asserts that any combination of colors can form a harami, but the most bearish are those that form with a black/white or black/black combination. Because the first candlestick has a large body, it implies that the bearish reversal pattern would be stronger if this body were black. This would indicate a sudden and sustained increase in selling pressure. The small candlestick afterwards indicates consolidation before continuation. After an advance, black/white or black/black bearish harami are not as common as white/black or white/white variations.
A white/black or white/white combination can still be regarded as a bearish harami and signal a potential reversal. The first long white candlestick forms in the direction of the trend. It signals that significant buying pressure remains, but could also indicate excessive bullishness. Immediately following, the small candlestick forms with a gap down on the open, indicating a sudden shift towards the sellers and a potential reversal.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-bearhar-amtd.png
After a gap up and rapid advance to 30, Ameritrade (AMTD)http://stockcharts.com/images/minilink_sc.gif formed a bearish harami (red oval). This harami consists of a long black candlestick and a small black candlestick. The decline two days later confirmed the bearish harami and the stock fell to the low twenties.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-bearhar-mrk.png
Merck (MRK)http://stockcharts.com/images/minilink_sc.gif formed a bearish harami with a long white candlestick and long black candlestick (red oval). The long white candlestick confirmed the direction of the current trend. However, the stock gapped down the next day and traded in a narrow range. The decline three days later confirmed the pattern as bearish.
Evening StarThe evening star consists of three candlesticks:
A long white candlestick.
A small white or black candlestick that gaps above the close (body) of the previous candlestick. This candlestick can also be a doji, in which case the pattern would be a evening doji star.
[*]A long black candlestick.
The long white candlestick confirms that buying pressure remains strong and the trend is up. When the second candlestick gaps up, it provides further evidence of residual buying pressure. However, the advance ceases or slows significantly after the gap and a small candlestick forms, indicating indecision and a possible reversal of trend. If the small candlestick is a doji, the chances of a reversal increase. The third long black candlestick provides bearish confirmation of the reversal.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-evestar-t.png
After advancing from 68 to 91 in about two weeks, AT&T (T)http://stockcharts.com/images/minilink_sc.gif formed an evening star (red oval). The middle candlestick is a spinning top, which indicates indecision and possible reversal. The gap above 91 was reversed immediately with a long black candlestick. Even though the stock stabilized in the next few days, it never exceeded the top of the long black candlestick and subsequently fell below 75.
Bearish Abandoned BabyThe bearish abandoned baby resembles the evening doji star and also consists of three candlesticks:
A long white candlestick.
A doji that gaps above the high of the previous candlestick.
[*]A long black candlestick that gaps below the low of the doji.
The main difference between the evening doji star and the bearish abandoned baby are the gaps on either side of the doji. The first gap up signals a continuation of the uptrend and confirms strong buying pressure. However, buying pressure subsides after the gap up and the security closes at or near the open, creating a doji. Following the doji, the gap down and long black candlestick indicate strong and sustained selling pressure to complete the reversal. Further bearish confirmation is not required.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/candlestick_bearish_reversal_patterns/bearrev2-abandon-dal.png
Delta (DAL)http://stockcharts.com/images/minilink_sc.gif formed an abandoned baby to mark a sharp reversal that carried the stock from 57 1/2 to 47 1/2. Although the open and close are not exactly equal, the small white candlestick in the middle captures the essence of a doji. Indecision is reflected with the small body and equal upper and lower shadows. In addition, the middle candlestick is separated by gaps on either side, which add emphasis to the reversal.
[ 本帖最后由 hefeiddd 于 2009-3-15 12:15 编辑 ]
Gaps and Gap AnalysisHave you ever wondered what causes gaps in price charts and what they mean? Well, you've come to the right place. Just in case, a gap is an area on a price chart in which there were no trades. Normally this occurs between the close of the market on one day and the next day's open. Lot's of things can cause this, such as an earnings report coming out after the stock market has closed for the day. If the earnings were significantly higher than expected, many investors might place buy orders for the next day. This could result in the price opening higher than the previous day's close. If the trading that day continues to trade above that point, a gap will exist in the price chart. Gaps can offer evidence that something important has happened to the fundamentals or the psychology of the crowd that accompanies this market movement. Before we get into the different types of gaps, here is a chart showing a gap so you will know what we are talking about.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/gaps_and_gap_analysis/GapChart1.png
Gaps appear more frequently on daily charts, where every day is an opportunity to create an opening gap. Gaps on weekly or monthly charts are fairly rare: the gap would have to occur between Friday's close and Monday's open for weekly charts and between the last day of the month's close and the first day of the next month's for the monthly charts. Gaps can be subdivided into four basic categories: Common, Breakaway, Runaway, and Exhaustion.
Common GapsSometimes referred to as a trading gap or an area gap, the common gap is usually uneventful. In fact, they can be caused by a stock going ex-dividend when the trading volume is low. These gaps are common (get it?) and usually get filled fairly quickly. "Getting filled" means that the price action at a later time (few days to a few weeks) usually retraces at the least to the last day before the gap. This is also known as closing the gap. Here is a chart of two common gaps that have been filled. Notice that after the gap the prices have come down to at least the beginning of the gap? That is called closing or filling the gap.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/gaps_and_gap_analysis/CommonGapsChart2.png
A common gap usually appears in a trading range or congestion area, and reinforces the apparent lack of interest in the stock at that time. Many times this is further exacerbated by low trading volume. Being aware of these types of gaps is good, but doubtful that they will produce a trading opportunities.
Breakaway GapsBreakaway gaps are the exciting ones. They occur when the price action is breaking out of their trading range or congestion area. To understand gaps, one has to understand the nature of congestion areas in the market. A congestion area is just a price range in which the market has traded for some period of time, usually a few weeks or so. The area near the top of the congestion area is usually resistance when approached from below. Likewise, the area near the bottom of the congestion area is support when approached from above. To break out of these areas requires market enthusiasm and, either, many more buyers than sellers for upside breakouts or more sellers than buyers for downside breakouts.
Volume will (should) pick up significantly, for not only the increased enthusiasm, but many are holding positions on the wrong side of the breakout and need to cover or sell them. It is better if the volume does not happen until the gap occurs. This means that the new change in market direction has a chance of continuing. The point of breakout now becomes the new support (if an upside breakout) or resistance (if a downside breakout). Don't fall into the trap of thinking this type of gap, if associated with good volume, will be filled soon. It might take a long time. Go with the fact that a new trend in the direction of the stock has taken place, and trade accordingly. Notice in the chart below how prices spent over 2 months without going lower than about 41. When they did, it was with increased volume and a downward breakaway gap.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/gaps_and_gap_analysis/BreakGapChart3.png
A good confirmation for trading gaps is if they are associated with classic chart patterns. For example, if an ascending triangle suddenly has a breakout gap to the upside, this can be a much better trade than a breakaway gap without a good chart pattern associated with it. The chart below shows the normally bullish ascending triangle (flat top and rising, lower trend line) with a breakaway gap to the upside, as you would expect with an ascending triangle.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/gaps_and_gap_analysis/BreakTrangleChart4.png
Runaway GapsRunaway gaps are also called measuring gaps, and are best described as gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the up trend and while waiting for a retracement in price, decided it was not going to happen. Increased buying interest happens all of a sudden, and the price gaps above the previous day's close. This type of runaway gap represents an almost panic state in traders. Also, a good uptrend can have runaway gaps caused by significant news events that cause new interest in the stock. In the chart below, note the significant increase in volume during and after the runaway gap.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/gaps_and_gap_analysis/RunawayChart5.png
Runaway gaps can also happen in downtrends. This usually represents increased liquidation of that stock by traders and buyers who are standing on the sidelines. These can become very serious as those who are holding onto the stock will eventually panic and sell – but sell to whom? The price has to continue to drop and gap down to find buyers. Not a good situation.
The term measuring gap is also used for runaway gaps. This is an interpretation that is hard to find examples for, but it is a way of helping one decide how much longer a trend will last. The theory is that the measuring gap will occur in the middle, or half way, through the move.
Sometimes, the futures market will have runaway gaps that are caused by trading limits imposed by the exchanges. Getting caught on the wrong side of the trend when you have these limit moves in futures can be horrifying. The good news is that you can also be on the right side of them. These are not common occurrences in the futures market despite all the wrong information being touted by those who do not understand it, and are only repeating something they read from an uninformed reporter.
Exhaustion GapsExhaustion gaps are those that happen near the end of a good up- or downtrend. They are many times the first signal of the end of that move. They are identified by high volume and large price difference between the previous day's close and the new opening price. They can easily be mistaken for runaway gaps if one does not notice the exceptionally high volume.
It is almost a state of panic if the gap appears during a long down move and pessimism has set in. Selling all positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly filled as prices reverse their trend. Likewise, if they happen during a bull move, some bullish euphoria overcomes trades, and buyers cannot get enough of that stock. The prices gap up with huge volume; then, there is great profit taking and the demand for the stock totally dries up. Prices drop, and a significant change in trend occurs. Exhaustion gaps are probably the easiest to trade and profit from. In the chart, notice that there was one more day of trading to the upside before the stock plunged. The high volume was the giveaway that this was going to be, either, an exhaustion gap or a runaway gap. Because of the size of the gap and the near doubling of volume, an exhaustion gap was in the making here.
http://stockcharts.com/school/data/media/chart_school/chart_analysis/gaps_and_gap_analysis/ExhaustionChart6.png
ConclusionThere is an old saying that the market abhors a vacuum and all gaps will be filled. While this may have some merit for common and exhaustion gaps, holding positions waiting for breakout or runaway gaps to be filled can be devastating to your portfolio. Likewise, waiting to get on-board a trend by waiting for prices to fill a gap can cause you to miss the big move. Gaps are a significant technical development in price action and chart analysis, and should not be ignored. Japanese candlestick analysis is filled with patterns that rely on gaps to fulfill their objectives.
Introduction to Technical Indicators and Oscillators
IntroductionThis article is designed to introduce the concept of technical indicators and explain how to use them in your analysis. We will shed light on the difference between leading and lagging indicators, as well as look into the benefits and drawbacks. Many, if not most, popular indicators are shown as oscillators. With this in mind, we will also show how to read oscillators and explain how signals are derived. Later we will turn our focus to specific technical indicators and provide examples of signals in action.
What Is a Technical Indicator?Advertisement
A technical indicator is a series of data points that are derived by applying a formula to the price data of a security. Price data includes any combination of the open, high, low or close over a period of time. Some indicators may use only the closing prices, while others incorporate volume and open interest into their formulas. The price data is entered into the formula and a data point is produced.
For example, the average of 3 closing prices is one data point ( (41+43+43) / 3 = 42.33 ). However, one data point does not offer much information and does not an indicator make. A series of data points over a period of time is required to create valid reference points to enable analysis. By creating a time series of data points, a comparison can be made between present and past levels. For analysis purposes, technical indicators are usually shown in a graphical form above or below a security's price chart. Once shown in graphical form, an indicator can then be compared with the corresponding price chart of the security. Sometimes indicators are plotted on top of the price plot for a more direct comparison.
What Does a Technical Indicator Offer?A technical indicator offers a different perspective from which to analyze the price action. Some, such as moving averages, are derived from simple formulas and the mechanics are relatively easy to understand. Others, such as Stochastics, have complex formulas and require more study to fully understand and appreciate. Regardless of the complexity of the formula, technical indicators can provide unique perspective on the strength and direction of the underlying price action.
A simple moving average is an indicator that calculates the average price of a security over a specified number of periods. If a security is exceptionally volatile, then a moving average will help to smooth the data. A moving average filters out random noise and offers a smoother perspective of the price action. Veritas (VRTS) displays a lot of volatility and an analyst may have difficulty discerning a trend. By applying a 10-day simple moving average to the price action, random fluctuations are smoothed to make it easier to identify a trend.
http://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/introduction_to_technical_indicators_and_oscillators/indic1-vrts.png
Why Use Indicators?Indicators serve three broad functions: to alert, to confirm and to predict.
An indicator can act as an alert to study price action a little more closely. If momentum is waning, it may be a signal to watch for a break of support. Or, if there is a large positive divergence building, it may serve as an alert to watch for a resistance breakout.
Indicators can be used to confirm other technical analysis tools. If there is a breakout on the price chart, a corresponding moving average crossover could serve to confirm the breakout. Or, if a stock breaks support, a corresponding low in the On-Balance-Volume (OBV) could serve to confirm the weakness.
[*]Some investors and traders use indicators to predict the direction of future prices.
Tips for Using IndicatorsIndicators indicate. This may sound straightforward, but sometimes traders ignore the price action of a security and focus solely on an indicator. Indicators filter price action with formulas. As such, they are derivatives and not direct reflections of the price action. This should be taken into consideration when applying analysis. Any analysis of an indicator should be taken with the price action in mind. What is the indicator saying about the price action of a security? Is the price action getting stronger? Weaker?
Even though it may be obvious when indicators generate buy and sell signals, the signals should be taken in context with other technical analysis tools. An indicator may flash a buy signal, but if the chart pattern shows a descending triangle with a series of declining peaks, it may be a false signal.
On the Rambus (RMBS) chart, MACD improved from November to March, forming a positive divergence. All the earmarks of a MACD buying opportunity were present, but the stock failed to break above the resistance and exceed its previous reaction high. This non-confirmation from the stock should have served as a warning sign against a long position. For the record, a sell signal occurred when the stock broke support from the descending triangle in March-01.
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As always in technical analysis, learning how to read indicators is more of an art than a science. The same indicator may exhibit different behavioral patterns when applied to different stocks. Indicators that work well for IBM might not work the same for Delta Airlines. Through careful study and analysis, expertise with the various indicators will develop over time. As this expertise develops, certain nuances as well as favorite setups will become clear.
There are hundreds of indicators in use today, with new indicators being created every week. Technical analysis software programs come with dozens of indicators built in, and even allow users to create their own. Given the amount of hype that is associated with indicators, choosing an indicator to follow can be a daunting task. Even with the introduction of hundreds of new indicators, only a select few really offer a different perspective and are worthy of attention. Strangely enough, the indicators that usually merit the most attention are those that have been around the longest time and have stood the test of time.
When choosing an indicator to use for analysis, choose carefully and moderately. Attempts to cover more than five indicators are usually futile. It is best to focus on two or three indicators and learn their intricacies inside and out. Try to choose indicators that complement each other, instead of those that move in unison and generate the same signals. For example, it would be redundant to use two indicators that are good for showing overbought and oversold levels, such as Stochastics and RSI. Both of these indicators measure momentum and both have overbought/oversold levels.
Leading IndicatorsAdvertisement
As their name implies, leading indicators are designed to lead price movements. Most represent a form of price momentum over a fixed look-back period, which is the number of periods used to calculate the indicator. For example, a 20-day Stochastic Oscillator would use the past 20 days of price action (about a month) in its calculation. All prior price action would be ignored. Some of the more popular leading indicators include Commodity Channel Index (CCI), Momentum, Relative Strength Index (RSI), Stochastic Oscillator and Williams %R.
Momentum OscillatorsMany leading indicators come in the form of momentum oscillators. Generally speaking, momentum measures the rate-of-change of a security's price. As the price of a security rises, price momentum increases. The faster the security rises (the greater the period-over-period price change), the larger the increase in momentum. Once this rise begins to slow, momentum will also slow. As a security begins to trade flat, momentum starts to actually decline from previous high levels. However, declining momentum in the face of sideways trading is not always a bearish signal. It simply means that momentum is returning to a more median level.
RSIhttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/introduction_to_technical_indicators_and_oscillators/indic2-rsi-ibm.png
Momentum indicators employ various formulas to measure price changes. RSI (a momentum indicator) compares the average price change of the advancing periods with the average change of the declining periods. On the IBM chart, RSI advanced from October to the end of November. During this period, the stock advanced from the upper 60s to the low 80s. When the stock traded sideways in the first half of December, RSI dropped rather sharply (blue lines). This consolidation in the stock was quite normal and actually healthy. From these lofty levels (near 70), flat price action would be expected to cause a a decline in RSI (and momentum). If RSI were trading around 50 and the stock began to trade flat, the indicator would not be expected to decline. The green lines on the chart mark a period of sideways trading in the stock and in RSI. RSI started from a relatively median level, around 50. The subsequent flat price action in the stock also produced relatively flat price action in the indicator and it remains around 50.
Benefits and Drawbacks of Leading IndicatorsThere are clearly many benefits to using leading indicators. Early signaling for entry and exit is the main benefit. Leading indicators generate more signals and allow more opportunities to trade. Early signals can also act to forewarn against a potential strength or weakness. Because they generate more signals, leading indicators are best used in trading markets. These indicators can be used in trending markets, but usually with the major trend, not against it. In a market trending up, the best use is to help identify oversold conditions for buying opportunities. In a market that is trending down, leading indicators can help identify overbought situations for selling opportunities.
With early signals comes the prospect of higher returns and with higher returns comes the reality of greater risk. More signals and earlier signals mean that the chances of false signals and whipsaws increase. False signals will increase the potential for losses. Whipsaws can generate commissions that can eat away profits and test trading stamina.
Lagging IndicatorsAs their name implies, lagging indicators follow the price action and are commonly referred to as trend-following indicators. Rarely, if ever, will these indicators lead the price of a security. Trend-following indicators work best when markets or securities develop strong trends. They are designed to get traders in and keep them in as long as the trend is intact. As such, these indicators are not effective in trading or sideways markets. If used in trading markets, trend-following indicators will likely lead to many false signals and whipsaws. Some popular trend-following indicators include moving averages (exponential, simple, weighted, variable) and MACD.
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The chart above shows the S&P 500 ($SPX)http://stockcharts.com/images/minilink_sc.gif with the 20-day simple moving average and the 100-day simple moving average. Using a moving average crossover to generate the signals, there were seven signals over the two years covered in the chart. Over these two years, the system would have been enormously profitable. This is due to the strong trends that developed from Oct-97 to Aug-98 and from Nov-98 to Aug-99. However, notice that as soon as the index starts to move sideways in a trading range, the whipsaws begin. The signals in Nov-97 (sell), Aug-99 (sell) and Sept-99 (buy) were reversed in a matter of days. Had these moving averages been longer (50- and 200-day moving averages), there would have been fewer whipsaws. Had these moving average been shorter (10 and 50-day moving average), there would have been more whipsaws, more signals, and earlier signals.
Benefits and Drawbacks of Lagging IndicatorsOne of the main benefits of trend-following indicators is the ability to catch a move and remain in a move. Provided the market or security in question develops a sustained move, trend-following indicators can be enormously profitable and easy to use. The longer the trend, the fewer the signals and less trading involved.
The benefits of trend-following indicators are lost when a security moves in a trading range. In the S&P 500 example, the index appears to have been range-bound at least 50% of the time. Even though the index trended higher from 1982 to 1999, there have also been large periods of sideways movement. From 1964 to 1980, the index traded within a large range bound by 85 and 110.
Another drawback of trend-following indicators is that signals tend to be late. By the time a moving average crossover occurs, a significant portion of the move has already occurred. The Nov-98 buy signal occurred at 1130, about 19% above the Oct-98 low of 950. Late entry and exit points can skew the risk/reward ratio.
The Challenge of IndicatorsFor technical indicators, there is a trade-off between sensitivity and consistency. In an ideal world, we want an indicator that is sensitive to price movements, gives early signals and has few false signals (whipsaws). If we increase the sensitivity by reducing the number of periods, an indicator will provide early signals, but the number of false signals will increase. If we decrease sensitivity by increasing the number of periods, then the number of false signals will decrease, but the signals will lag and and this will skew the reward-to-risk ratio.
The longer a moving average is, the slower it will react and fewer signals will be generated. As the moving average is shortened, it becomes faster and more volatile, increasing the number of false signals. The same holds true for the various momentum indicators. A 14 period RSI will generate fewer signals than a 5 period RSI. The 5 period RSI will be much more sensitive and have more overbought and oversold readings. It is up to each investor to select a time frame that suits his or her trading style and objectives.
Oscillator TypesAn oscillator is an indicator that fluctuates above and below a centerline or between set levels as its value changes over time. Oscillators can remain at extreme levels (overbought or oversold) for extended periods, but they cannot trend for a sustained period. In contrast, a security or a cumulative indicator like On-Balance-Volume (OBV) can trend as it continually increases or decreases in value over a sustained period of time.
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As the indicator comparison chart shows, oscillator movements are more confined and sustained movements (trends) are limited, no matter how long the time period. Over the two year period, Moving Average Convergence Divergence (MACD) fluctuated above and below zero, touching the zero line about 18 times. Also notice that each time MACD surpassed +80 the indicator pulled back. Even though MACD does not have an upper or lower limit on its range of values, its movements appear confined. OBV, on the other hand, began an uptrend in March 2003 and advanced steadily for the next year. Its movements are not confined and long-term trends can develop.
There are many different types of oscillators and some belong to more than one category. The breakdown of oscillator types begins with two types: centered oscillators which fluctuate above and below a center point or line, and banded oscillators which fluctuate between overbought and oversold extremes. Generally, centered oscillators are best suited for analyzing the direction of price momentum, while banded oscillators are best suited for identifying overbought and oversold levels.
Centered OscillatorsCentered oscillators fluctuate above and below a central point or line. These oscillators are good for identifying the strength or weakness, or direction, of momentum behind a security's move. In its purest form, momentum is positive (bullish) when a centered oscillator is trading above its center line and negative (bearish) when the oscillator is trading below its center line.
MACD is an example of a centered oscillator that fluctuates above and below zero. MACD is the difference between the 12-day EMA and 26-day EMA of a security. The further one moving average moves away from the other, the higher the reading. Even though there is no range limit to MACD, extremely large differences between the two moving averages are unlikely to last for long.
MACDMACD is unique in that it has lagging elements as well as leading elements. Moving averages are lagging indicators and would be classified as trend-following or lagging elements. However, by taking the differences in the moving averages, MACD incorporates aspects of momentum or leading elements. The difference between the moving averages represents the rate of change. By measuring the rate-of-change, MACD becomes a leading indicator, but still with a bit of lag. With the integration of both moving averages and rate-of-change, MACD has forged a unique spot among oscillators as both a lagging and a leading indicator.
ROCRate-of-change (ROC) is a centered oscillator that also fluctuates above and below zero. As its name implies, ROC measures the percentage price change over a given time period. For example: 20 day ROC would measure the percentage price change over the last 20 days. The bigger the difference between the current price and the price 20 days ago, the higher the value of the ROC Oscillator. When the indicator is above 0, the percentage price change is positive (bullish). When the indicator is below 0, the percentage price change is negative (bearish).
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As with MACD, ROC is not bound by upper or lower limits. This is typical of most centered oscillators and can make it difficult to spot overbought and oversold conditions. This ROC chart indicates that readings above +20% and below -20% represent extremes and are unlikely to last for an extended period of time. However, the only way to gauge that +20% and -20% are extreme readings is from past observations. Also, +20% and -20% represent extremes for this particular security and may not be the same for other securities. Banded oscillators offer a better alternative to gauge extreme price levels.
Banded OscillatorsBanded oscillators fluctuate above and below two bands that signify extreme price levels. The lower band represents oversold readings and the upper band represents overbought readings. These set bands are based on the oscillator and change little from security to security, allowing the users to easily identify overbought and oversold conditions. The Relative Strength Index (RSI) and the Stochastic Oscillator are two examples of banded oscillators. (Note: The formulas and rationale behind RSI and the Stochastic Oscillator are more complicated than those for MACD and ROC. As such, calculations are addressed in separate articles.)
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For RSI, the bands for overbought and oversold are usually set at 70 and 30 respectively. A reading greater than 70 would be considered overbought and a reading below 30 would be considered oversold. For the Stochastic Oscillator, a reading above 80 is overbought and a reading below 20 oversold. Even though these are the recommended band settings, certain securities may not adhere to these ranges and might require more fine-tuning. Making adjustments to the bands is usually a judgment call that will reflect a trader's preferences and the volatility of the security.
Many, but not all, banded oscillators fluctuate within set upper and lower limits. The Relative Strength Index (RSI) is range-bound by 0 and 100 and will never go higher than 100 nor lower than zero. The Stochastic Oscillator is another oscillator with a set range and is bound by 100 and 0 as well. However, the Commodity Channel Index (CCI) is an example of a banded oscillator that is not range bound.
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Pros and Cons of Centered and Banded OscillatorsCentered oscillators are best used to identify the underlying strength or direction of momentum behind a move. Broadly speaking, readings above the center point indicate bullish momentum and readings below the center point indicate bearish momentum. The biggest difference between centered oscillators and banded oscillators is the latter's ability to identify extreme readings. While it is possible to identify extreme readings with centered oscillators, they are not ideal for this purpose. Banded oscillators are best suited to identify overbought and oversold conditions.
Oscillator SignalsOscillators generate buy and sell signals in various ways. Some signals are geared towards early entry, while others appear after the trend has begun. In addition to buy and sell signals, oscillators can signal that something is amiss with the current trend or that the current trend is about to change. Even though oscillators can generate their own signals, it is important to use these signals in conjunction with other aspects of technical analysis. Most oscillators are momentum indicators and only reflect one characteristic of a security's price action. Volume, price patterns and support/resistance levels should also be taken into consideration.
Positive and Negative DivergencesDivergence is a key concept behind many signals for oscillators as well as other indicators. Divergences can serve as a warning that the trend is about to change or set up a buy or sell signal. There are two types of divergences: positive and negative. In its most basic form, a positive divergence occurs when the indicator advances and the underlying security declines. A negative divergence occurs when an indicator declines and the underlying security advances.
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On the Merrill Lynch (MER)http://stockcharts.com/images/minilink_sc.gif chart, MACD formed a positive divergence in late October. While MER was trading below its previous reaction low, MACD had yet to penetrate its previous low (green arrows). However, MACD had not turned up and the positive divergence was still just a possibility. When MACD turned up and traded above its 9-day EMA, a positive divergence was confirmed. At this point, other signals came together to create a buy signal. Not only had the stock reached support and gapped up, but there was also a MACD positive divergence and a MACD bullish crossover. (Note: The thick line is the MACD and the thin line is the 9-day EMA of the MACD, which acts as a trigger line. A bullish crossover occurs when MACD moves above its 9-day EMA and a bearish crossover occurs when MACD moves below its 9-day EMA.) After these MACD signals, the stock gapped up the very next day on a huge increase in volume.
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On the IBMhttp://stockcharts.com/images/minilink_sc.gif chart, the ROC Oscillator formed a negative divergence prior to the decline that began in January. When IBM recorded a high in mid January, the ROC Oscillator failed to surpass its previous high. The stock then began to decline and the ROC Oscillator turned lower as well, thus completing the lower high and the negative divergence. As there was little else to go on at the time, this negative divergence should have been taken as a warning signal. However, when the ROC Oscillator continued to deteriorate and broke below 0 (centerline), it was clear that the stock was weak and vulnerable to a further decline.
Overbought and Oversold ExtremesBanded oscillators are designed to identify overbought and oversold extremes. Since these oscillators fluctuate between extremes, they can be difficult to use in trending markets. Banded oscillators are best used in trading ranges or with securities that are not trending. In a strong trend, users may see many signals that are not really valid. If a stock is in a strong uptrend, buying on oversold conditions will work much better than selling on overbought conditions.
In a strong trend, oscillator signals against the direction of the underlying trend are less robust than those with the trend. The trend is your friend and it can be dangerous to fight it. Even though securities develop trends, they also fluctuate within those trends. If a stock is in a strong uptrend, buying when oscillators reach oversold conditions (and near support tests) will work much better than selling on overbought conditions. During a strong downtrend, selling when oscillators reach overbought conditions would work much better. If the path of least resistance is up (down), then acting on only bullish (bearish) signals would be in harmony with the trend. Attempts to trade against the trend carry added risk.
When the trend is strong, banded oscillators can remain near overbought or oversold levels for extended periods. An overbought condition does not indicate that it is time to sell, nor does an oversold condition indicate that it is time to buy. In a strong uptrend, an oscillator can reach an overbought condition and remain so as the underlying security continues to advance. A negative divergence may form, but a bearish signal against the uptrend should be considered suspect. In a strong downtrend, an oscillator can reach an oversold condition and remain so as the underlying security continues to decline. Similarly, a positive divergence may form, but a bullish signal against the downtrend should be considered suspect. This does not mean counter-trend signals won't work, but they should be viewed in proper context and considered with other aspects of technical analysis.
The first step in using banded oscillators is to identify the upper and lower bands that mark the extremities. For RSI, anything below 30 and above 70 represents an extremity. For the Stochastic Oscillator, anything below 20 and above 80 represents an extremity. We know that when RSI is below 30 or the Stochastic Oscillator is below 20, an oversold condition exists. By that same token, when RSI is above 70 and the Stochastic Oscillator is above 80, an overbought condition exists. Identification of an overbought or oversold condition should serve as an alert to monitor other technical aspects (price pattern, trend, support, resistance, candlesticks, volume or other indicators) with extra vigilance.
The simplest method to generate signals is to note when the upper and lower bands are crossed. If a security is overbought (above 70 for RSI and 80 for the Stochastic Oscillator) and moves back down below the upper band, then a sell signal is generated. If a security is oversold (below 30 for RSI and 20 for the Stochastic Oscillator) and moves back above the lower band, then a buy signal is generated. Keep in mind that these are the simplest methods.
Simple signals can also be combined with divergences and moving average crossovers to create more robust signals. Once a stock becomes oversold, traders may look for a positive divergence to develop in the RSI and then a cross above 30. With the Stochastic Oscillator overbought, traders may look for a negative divergence and combine that with a moving average crossover and a break below 80 to generate a signal. (Note: The Stochastic Oscillator is usually plotted with a 3-day simple moving average that acts as the trigger line. When the Stochastic Oscillator crosses above the trigger line it is a bullish moving average crossover, and when it crosses below it is bearish).
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The Cisco (CSCO)http://stockcharts.com/images/minilink_sc.gif chart shows that the Stochastic Oscillator can change from oversold to overbought quite quickly. Much depends on the number of time periods used to calculate the oscillator. A 10-day Slow Stochastic Oscillator will be more volatile than a 20-day. The thin green lines indicate when the Stochastic Oscillator touched or crossed the oversold line at 20. The thin red lines indicate when Stochastic Oscillator touched or crossed the overbought line. CSCO was in a strong up trend at the time and experiencing little selling pressure. Therefore, trying to sell when the oscillator crossed back below 80 would have been against the uptrend and not the proper strategy. When a security is trending up or has a bullish bias, traders would be better off looking for oversold conditions to generate buying opportunities.
We can also see that much of the upside for the stock occurred after the Stochastic Oscillator advanced above 80 (thin red lines). The green circle in August shows a buy signal that was generated with three separate items: one, the oscillator moved above 20 from oversold conditions; two, the oscillator moved above its 3-day MA; and three, the oscillator formed a positive divergence. Confirmation from these three items makes for a more robust signal. After the buy signal, the oscillator was in overbought territory a mere 4 days later. However, the stock continued its advance for 2-3 weeks before reaching its high.
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The Microsoft (MSFT)http://stockcharts.com/images/minilink_sc.gif chart reveals trading opportunities with the Relative Strength Index (RSI). Because a 14-period RSI rarely moved below 30 and above 70, a 10-period RSI was chosen to increase sensitivity. With the intermediate-term and long-term trends decidedly bearish, savvy traders could have sold short each time RSI reached overbought (black vertical lines). More aggressive traders could have played the long side each time RSI dipped below 30 and then moved back above this oversold level. The first two buy signals were generated with a positive divergence and a move above 30 from oversold conditions. The third buy signal came after RSI briefly dipped below 30. Keep in mind that these three signals were against the larger downtrend and trading strategies should be adjusted accordingly.
Centerline CrossoversAs the name implies, centerline crossover signals apply mainly to centered oscillators that fluctuate above and below a centerline. Traders have been also known to use centerline crosses with RSI in order validate a divergence or signal generated from an overbought or oversold reading. However, most banded oscillators, such as RSI and Stochastics, rely on divergences and overbought/oversold levels to generate signals. The middle ground is a bit of a no man's land for banded oscillators and is probably best left to other tools. For our purposes, the analysis of centerline crossovers will focus on centered oscillators such as Chaikin Money Flow, MACD and Rate-of-Change (ROC).
A centerline crossover is sometimes interpreted as a buy or sell signal. A buy signal would be generated with a cross above the centerline and a sell signal with a cross below the centerline. For MACD or ROC, a cross above or below zero would act as a signal.
Movements above or below the centerline indicate that momentum has changed from either positive to negative or negative to positive. When a centered momentum oscillator advances above its centerline, momentum turns positive and could be considered bullish. When a centered momentum oscillator declines below its centerline, momentum turns negative and could be considered bearish.
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On this Intel (INTC)http://stockcharts.com/images/minilink_sc.gif chart with MACD and ROC, there have been a number of signals generated from the centerline crossover. There were a couple of excellent signals, but there were also plenty of false signals and whipsaws. This highlights some of the challenges associated with trading oscillator signals. Also, it stresses the importance of combining various signals in order to create more robust buy and sell signals. Some traders also criticize centerline crossover signals as being too late and missing too much of the move.
A centerline crossover can also act as a confirmation signal to validate a previous signal or reinforce the current trend. If there were a positive divergence and bullish moving average crossover, then a subsequent advance above the centerline would confirm the previous buy signal. Failure of the oscillator to move above the centerline could be seen as a non-confirmation and act as an alert that something was amiss.
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On the Intel (INTC)http://stockcharts.com/images/minilink_sc.gif chart with MACD, the centerline crossover acts as the third in a series of bullish signals. Even after the third signal, Intel still has plenty of upside left.
There was the higher low forming that signaled a potential positive divergence.
There was the bullish moving average crossover to confirm the positive divergence.
[*]And finally, there was the bullish centerline crossover.
Some traders would worry about missing too much of the move by waiting for the third and final confirmation. However, this can be a more reliable signal and help to avoid whipsaws and false signals. It is true that waiting for the third signal will reduce profits, but it can also help reduce risk.
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Chaikin Money Flow is an example of a centered oscillator that places importance on crosses above and below the centerline. Divergences, overbought levels and oversold levels are all secondary to the absolute level of the indicator. The direction of the oscillator's movement is important, but needs to be placed in the context of the absolute level. The longer the oscillator is above zero, the more evidence of accumulation. The longer the oscillator is below zero, the more evidence of distribution. Hence, Chaikin Money Flow is considered to be bullish when the oscillator is trading above zero and bearish when trading below zero.
On the IBMhttp://stockcharts.com/images/minilink_sc.gif chart, Chaikin Money Flow began to turn down in July. At this time, the stock was declining with the market and the decline in the oscillator was normal. However, in the second half of August, concerns began to grow when the oscillator failed to continue up with the stock and fell below zero. As the stock advanced further, Chaikin Money Flow continued to deteriorate. This served as a signal that something was amiss.
Pros and Cons of Oscillator SignalsBanded oscillators are best used to identify overbought and oversold conditions. However, overbought is not meant to act as a sell signal, and oversold is not meant to act as a buy signal. Overbought and oversold situations serve as an alert that conditions are reaching extreme levels and close attention should be paid to the price action and other indicators.
To improve the robustness of oscillator signals, traders can look for multiple signals. The criteria for a buy or sell signal could depend on three separate yet confirming signals. A buy signal might be generated with an oversold reading, positive divergence and bullish moving average crossover. Conversely, a sell signal might be generated from a negative divergence, bearish moving average crossover and bearish centerline crossover.
Traditional chart pattern analysis can also be applied to oscillators. This is a bit trickier, but can help to identify the strength behind an oscillator's move. Looking for higher highs or lower lows can help confirm previous analysis. A trend line breakout can signal that a change in the direction of the momentum is imminent.
It is dangerous to trade an oscillator signal against the major trend of the market. In bull moves, it is best to look for buying opportunities through oversold signals, positive divergences, bullish moving average crossovers and bullish centerline crossovers. In bear moves, it is best to look for selling opportunities through overbought signals, negative divergences, bearish moving average crossovers and bearish centerline crossovers.
And finally, oscillators are most effective when used in conjunction with pattern analysis, support/resistance identification, trend identification and other technical analysis tools. By being aware of the broader picture, oscillator signals can be put into context. It is important to identify the current trend or even to ascertain if the security is trending at all. Oscillator readings and signals can have different meaning in differing circumstances. By using other analysis techniques in conjunction with oscillator reading, the chances of success can be greatly enhanced.
Moving Averages
IntroductionMoving averages are one of the most popular and easy to use tools available to the technical analyst. They smooth a data series and make it easier to spot trends, something that is especially helpful in volatile markets. They also form the building blocks for many other technical indicators and overlays.
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The two most popular types of moving averages are the Simple Moving Average (SMA) and the Exponential Moving Average (EMA). They are described in more detail below.
Simple Moving Average (SMA)(DACLNIMY]Click here for a live example of a Simple Moving Average)
A simple moving average is formed by computing the average (mean) price of a security over a specified number of periods. While it is possible to create moving averages from the Open, the High, and the Low data points, most moving averages are created using the closing price. For example: a 5-day simple moving average is calculated by adding the closing prices for the last 5 days and dividing the total by 5.
10+ 11 + 12 + 13 + 14 = 60
(60 / 5) = 12
The calculation is repeated for each price bar on the chart. The averages are then joined to form a smooth curving line - the moving average line. Continuing our example, if the next closing price in the average is 15, then this new period would be added and the oldest day, which is 10, would be dropped. The new 5-day simple moving average would be calculated as follows:
11 + 12 + 13 + 14 +15 = 65
(65 / 5) = 13
Over the last 2 days, the SMA moved from 12 to 13. As new days are added, the old days will be subtracted and the moving average will continue to move over time.
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In the example above, using closing prices from Eastman Kodak (EK), day 10 is the first day possible to calculate a 10-day simple moving average. As the calculation continues, the newest day is added and the oldest day is subtracted. The 10-day SMA for day 11 is calculated by adding the prices of day 2 through day 11 and dividing by 10. The averaging process then moves on to the next day where the 10-day SMA for day 12 is calculated by adding the prices of day 3 through day 12 and dividing by 10.
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The chart above is a plot that contains the data sequence in the table. The simple moving average begins on day 10 and continues.
This simple illustration highlights the fact that all moving averages are lagging indicators and will always be "behind" the price. The price of EK is trending down, but the simple moving average, which is based on the previous 10 days of data, remains above the price. If the price were rising, the SMA would most likely be below. Because moving averages are lagging indicators, they fit in the category of trend following indicators. When prices are trending, moving averages work well. However, when prices are not trending, moving averages can give misleading signals.
Exponential Moving Average (EMA)(DACLNIMY]Click here for a live example of an Exponential Moving Average)
In order to reduce the lag in simple moving averages, technicians often use exponential moving averages (also called exponentially weighted moving averages). EMA's reduce the lag by applying more weight to recent prices relative to older prices. The weighting applied to the most recent price depends on the specified period of the moving average. The shorter the EMA's period, the more weight that will be applied to the most recent price. For example: a 10-period exponential moving average weighs the most recent price 18.18% while a 20-period EMA weighs the most recent price 9.52%. As we'll see, the calculating and EMA is much harder than calculating an SMA. The important thing to remember is that the exponential moving average puts more weight on recent prices. As such, it will react quicker to recent price changes than a simple moving average. Here's the calculation formula.
Exponential Moving Average CalculationExponential Moving Averages can be specified in two ways - as a percent-based EMA or as a period-based EMA. A percent-based EMA has a percentage as it's single parameter while a period-based EMA has a parameter that represents the duration of the EMA.
The formula for an exponential moving average is:
EMA(current) = ( (Price(current) - EMA(prev) ) x Multiplier) + EMA(prev)
For a percentage-based EMA, "Multiplier" is equal to the EMA's specified percentage. For a period-based EMA, "Multiplier" is equal to 2 / (1 + N) where N is the specified number of periods.
For example, a 10-period EMA's Multiplier is calculated like this:
(2 / (Time periods + 1) ) = (2 / (10 + 1) ) = 0.1818 (18.18%)
This means that a 10-period EMA is equivalent to an 18.18% EMA.
Note: StockCharts.com only support period-based EMA's.
Below is a table with the results of an exponential moving average calculation for Eastman Kodak. For the first period's exponential moving average, the simple moving average was used as the previous period's exponential moving average (yellow highlight for the 10th period). From period 11 onward, the previous period's EMA was used. The calculation in period 11 breaks down as follows:
(C - P) = (57.15 - 59.439) = -2.289
(C - P) x K = -2.289 x .181818 = -0.4162
( (C - P) x K) + P = -0.4162 + 59.439 = 59.023
http://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/ema.png
*The 10-period simple moving average is used for the first calculation only. After that the previous period's EMA is used.
(Download this table as an Excel spreadsheet)
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Note that, in theory, every previous closing price in the data set is used in the calculation of each EMA that makes up the EMA line. While the impact of older data points diminishes over time, it never fully disappears. This is true regardless of the EMA's specified period. The effects of older data diminish rapidly for shorter EMA's. than for longer ones but, again, they never completely disappear.
Simple Versus ExponentialFrom afar, it would appear that the difference between an exponential moving average and a simple moving average is minimal. For this example, which uses only 20 trading days, the difference is minimal, but a difference nonetheless. The exponential moving average is consistently closer to the actual price. On average, the EMA is 3/8 of a point closer to the actual price than the SMA.
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From day 10 to day 20, the EMA was closer to the price than the SMA 8 out of 11 times. The average absolute difference between the exponential moving average and the current price was 1.52 and the simple moving average had an average absolute difference of 1.69. This means that on average, the exponential moving average was 1.52 point above or below the current price and the simple moving average was 1.69 points above or below the current price.
When Kodak stopped falling and started to trade flat, the SMA kept on declining. During this period, the SMA was closer to the actual price than the EMA. The EMA began to level out with the actual price, and remain further away. This was because the actual price started to level out. Because of its lag, the SMA continued to decline and nearly touched the actual price on 13-Dec.
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A comparison of a 50-day EMA and a 50-day SMA for IBM also shows that the EMA picks up on the trend quicker than the SMA. The blue arrows mark points when the stock started a strong trend. By giving more weight to recent prices, the EMA reacted quicker than the SMA and remained closer to the actual price. The gray circle shows when the trend began to slow and a trading range developed. When the change from trend to trading began, the SMA was closer to the price. As the trading range continued into 2001, both moving averages converged. In early 2001, CPQ started to trend up and the EMA was quicker to pick up on the recent price change and remain closer to the price.
Which is better?Which moving average you use will depend on your trading and investing style and preferences. The simple moving average obviously has a lag, but the exponential moving average may be prone to quicker breaks. Some traders prefer to use exponential moving averages for shorter time periods to capture changes quicker. Some investors prefer simple moving averages over long time periods to identify long-term trend changes. In addition, much will depend on the individual security in question. A 50-day SMA might work great for identifying support levels in the NASDAQ, but a 100-day EMA may work better for the Dow Transports. Moving average type and length of time will depend greatly on the individual security and how it has reacted in the past.
The initial thought for some is that greater sensitivity and quicker signals are bound to be beneficial. This is not always true and brings up a great dilemma for the technical analyst: the trade off between sensitivity and reliability. The more sensitive an indicator is, the more signals that will be given. These signals may prove timely, but with increased sensitivity comes an increase in false signals. The less sensitive an indicator is, the fewer signals that will be given. However, less sensitivity leads to fewer and more reliable signals. Sometimes these signals can be late as well.
For moving averages, the same dilemma applies. Shorter moving averages will be more sensitive and generate more signals. The EMA, which is generally more sensitive than the SMA, will also be likely to generate more signals. However, there will also be an increase in the number of false signals and whipsaws. Longer moving averages will move slower and generate fewer signals. These signals will likely prove more reliable, but they also may come late. Each investor or trader should experiment with different moving average lengths and types to examine the trade-off between sensitivity and signal reliability.
Trend-Following IndicatorAdvertisement
Moving averages smooth out a data series and make it easier to identify the direction of the trend. Because past price data is used to form moving averages, they are considered lagging, or trend following, indicators. Moving averages will not predict a change in trend, but rather follow behind the current trend. Therefore, they are best suited for trend identification and trend following purposes, not for prediction.
When to UseBecause moving averages follow the trend, they work best when a security is trending and are ineffective when a security moves in a trading range. With this in mind, investors and traders should first identify securities that display some trending characteristics before attempting to analyze with moving averages. This process does not have to be a scientific examination. Usually, a simple visual assessment of the price chart can determine if a security exhibits characteristics of trend.
In its simplest form, a security's price can be doing only one of three things: trending up, trending down or trading in a range. An uptrend is established when a security forms a series of higher highs and higher lows. A downtrend is established when a security forms a series of lower lows and lower highs. A trading range is established if a security cannot establish an uptrend or downtrend. If a security is in a trading range, an uptrend is started when the upper boundary of the range is broken and a downtrend begins when the lower boundary is broken.
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In the Ford (F)http://stockcharts.com/images/minilink_sc.gif example, it is evident that a stock can go through both trending and trading phases. The red circles indicate trading range phases that are interspersed among trending periods. It is sometimes difficult to determine when a trend will stop and a trading range will begin or when a trading range will stop and a trend will begin. The basic rules for trends and trading ranges laid out above can be applied to Ford. Notice the trading range periods, the breakouts (both up and down) and the trending periods. The moving average worked well in times of trend, but faired poorly in times of trading. Also note how the moving average lags behind the trend: it is always under the price during an uptrend and above the price during a downtrend. A 50-day simple moving average was used for this example. However, the number of periods is optional and much will depend on the characteristics of the security as well as an individual's trading and investing style.
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If price movements are choppy and erratic over an extended period of time, then a moving average is probably not the best choice for analysis. The chart for Coca-Cola (KO)http://stockcharts.com/images/minilink_sc.gif shows a security that moved from 60 to 40 in a couple months in 2001. Prior to this decline, the price gyrated above and below its moving average. After the decline, the stock continued its erratic behavior without developing much of a trend. Trying to analyze this security based on a moving average is likely to be a lesson in futility.
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A quick look at the chart for Time Warner (TWX)http://stockcharts.com/images/minilink_sc.gif shows a different picture. Over the same time period, Time Warner has shown the ability to trend. There are 3 distinct trends or price movements that extend for a number of months. Once the stock moves above or below the 70-day SMA, it usually continues in that direction for a little while longer. Coca-Cola, on the other hand, broke above and below its 70-day SMA numerous times and would have been prone to numerous whipsaws. A longer moving average might work better, but it is clear that the Time Warner chart had better trending characteristics.
Moving Average SettingsOnce a security has been deemed to have enough characteristics of trend, the next task will be to select the number of moving average periods and type of moving average. The number of periods used in a moving average will vary according to the security's volatility, trendiness and personal preferences. The more volatility there is, the more smoothing that will be required and hence the longer the moving average. Stocks that do not exhibit strong characteristics of trend may also require longer moving averages. There is no one set length, but some of the more popular lengths include 21, 50, 89, 150 and 200 days as well as 10, 30 and 40 weeks. Short-term traders may look for evidence of 2-3 week trends with a 21-day moving average, while longer-term investors may look for evidence of 3-4 month trends with a 40-week moving average. Trial and error is usually the best means for finding the best length. Examine how the moving average fits with the price data. If there are too many breaks, lengthen the moving average to decrease its sensitivity. If the moving average is slow to react, shorten the moving average to increase its sensitivity. In addition, you may want to try using both simple and exponential moving averages. Exponential moving averages are usually best for short-term situations that require a responsive moving average. Simple moving averages work well for longer-term situations that do not require a lot of sensitivity.
Uses for Moving AveragesThere are many uses for moving averages, but three basic uses stand out:
Trend identification/confirmation
Support and Resistance level identification/confirmation
[*]Trading Systems
Trend Identification/ConfirmationThere are three ways to identify the direction of the trend with moving averages: direction, location and crossovers.
The first trend identification technique uses the direction of the moving average to determine the trend. If the moving average is rising, the trend is considered up. If the moving average is declining, the trend is considered down. The direction of a moving average can be determined simply by looking at a plot of the moving average or by applying an indicator to the moving average. In either case, we would not want to act on every subtle change, but rather look at general directional movement and changes.
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In the case of Disney (DIS)http://stockcharts.com/images/minilink_sc.gif, a 100-day exponential moving average (EMA) has been used to determine the trend. We do not want to act on every little change in the moving average, but rather significant upturns and downturns. This is not a scientific study, but a number of significant turning points can be spotted just based on visual observation (red circles). A few good signals were rendered, but also a few whipsaws and late signals. Much of the performance would depend on your entry and exit points. The length of the moving average influences the number of signals and their timeliness. Moving averages are lagging indicators. Therefore, the longer the moving average is, the further behind the price movement it will be. For quicker signals, a 50-day EMA could have been used.
The second technique for trend identification is price location. The location of the price relative to the moving average can be used to determine the basic trend. If the price is above the moving average, the trend is considered up. If the price is below the moving average, the trend is considered down.
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This example is pretty straightforward. The long-term for Cisco (CSCO)http://stockcharts.com/images/minilink_sc.gif is determined by the location of the stock relative to its 100-day SMA. When CSCO is above its 100-day SMA, the trend is considered bullish. When the stock is below the 100-day SMA, the trend is considered bearish. Buy and sell signals are generated by crosses above and below the moving average. There was a brief sell signal generated in Aug-99 and a false buy signal in July-00. Both of these signals occurred when Cisco's trend began to weaken. For the most part though, this simple method would have kept an investor in throughout most of the bull move.
The third technique for trend identification is based on the location of the shorter moving average relative to the longer moving average. If the shorter moving average is above the longer moving average, the trend is considered up. If the shorter moving average is below the longer moving average, the trend is considered down.
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For Inter-Tel (INTL)http://stockcharts.com/images/minilink_sc.gif, a 30/100 moving average crossover was used to determine the trend. When the 30-day moving average moves above the 100-day moving average, the trend is considered bullish. When the 30-day moving average declines below the 100-day moving average, the trend is considered bearish. A plot of the 30/100 differential is plotted below the price chart by using the Percentage Price Oscillator (PPO) set to (30,100,1). When the differential is positive the trend is considered up – when it is negative the trend is considered down. As with all trend-following systems, the signals work well when the stock develops a strong trend, but are ineffective when the stock is in a trading range. Also notice that the signals tend to be late and after the move has begun. Again, trend following indicators are best for identification and following, not predicting.
Support and Resistance LevelsAnother use of moving averages is to identify support and resistance levels. This is usually accomplished with one moving average and is based on historical precedent. As with trend identification, support and resistance level identification through moving averages works best in trending markets.
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After breaking out of a trading range, Sun Microsystems (SUNW)http://stockcharts.com/images/minilink_sc.gif successfully tested moving average support in late July and early August. Also notice that the June resistance breakout near 18 turned into support. Therefore, the moving average acted as a confirmation of resistance-turned-support. After this first test, the 50-day moving average went on to 4 more successful support tests over the next several months. A break of support from the 50-day moving average would serve as a warning that the stock may move into a trading range or may be about to change the direction of the trend. Such a break occurred in Apr-00 and the 50-day SMA turned into resistance later that month. When the stock broke above the 50-day SMA in early Jun-00, it returned to a support level until the Oct-00 break. In Oct-00, the 50-day SMA became a resistance level and that held for many months.
Moving Averages and SharpChartshttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/ma/MAtable.gif
Moving averages are available as a price overlay feature on SharpCharts. From the price overlay option, you can choose either a simple moving average or an exponential moving average. The first parameter is used to set the number of time periods. If charting on daily periods, then 50 would be for a 50-day moving average. If charting on weekly periods, then 50 would be for a 50-week moving average. An optional second parameter can be used to shift the MA lines to the left or right by a specified number of periods. The moving averages are based on closing prices and multiple moving averages can be overlaid the price plot.
(daclnnay]Click here for a live example of a Simple Moving Average and an Exponential Moving Average)
ConclusionsMoving averages can be effective tools to identify and confirm trend, identify support and resistance levels, and develop trading systems. However, traders and investors should learn to identify securities that are suitable for analysis with moving averages and how this analysis should be applied. Usually, an assessment can be made with a visual examination of the price chart, but sometimes it will require a more detailed approach. The ADX, Average Directional Index, is one tool that can help identify securities that are trending and those that are not.
The advantages of using moving averages need to be weighed against the disadvantages. Moving averages are trend following, or lagging, indicators that will always be a step behind. This is not necessarily a bad thing though. After all, the trend is your friend and it is best to trade in the direction of the trend. Moving averages will help ensure that a trader is in line with the current trend. However, markets, stocks and securities spend a great deal of time in trading ranges, which render moving averages ineffective. Once in a trend, moving averages will keep you in, but also give late signals. Don't expect to get out at the top and in at the bottom using moving averages. As with most tools of technical analysis, moving averages should not be used on their own, but in conjunction with other tools that complement them. Using moving averages to confirm other indicators and analysis can greatly enhance technical analysis.
Bollinger Bands
IntroductionDeveloped by John Bollinger, Bollinger Bands are an indicator that allows users to compare volatility and relative price levels over a period time. The indicator consists of three bands designed to encompass the majority of a security's price action.
A simple moving average in the middle
An upper band (SMA plus 2 standard deviations)
[*]A lower band (SMA minus 2 standard deviations)
Standard deviation is a statistical unit of measure that provides a good assessment of a price plot's volatility. Using the standard deviation ensures that the bands will react quickly to price movements and reflect periods of high and low volatility. Sharp price increases (or decreases), and hence volatility, will lead to a widening of the bands.
Calculationhttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/bollinger_bands/bbands-formula.gif
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The center band is the 20-day simple moving average. The upper band is the 20-day simple moving average plus 2 standard deviations. The lower band is the 20-day simple moving average less 2 standard deviations.
SettingsClosing prices are most often used to compute Bollinger Bands. Other variations, including typical and weighted prices, can also be used.
Typical Price = (high + low + close)/3
[*]Weighted Price = (high + low + close + close)/4
Bollinger recommends using a 20-day simple moving average for the center band and 2 standard deviations for the outer bands. The length of the moving average and number of deviations can be adjusted to better suit individual preferences and specific characteristics of a security.
Trial and error is one method to determine an appropriate moving average length. A simple visual assessment can be used to determine the appropriate number of periods. Bollinger Bands should encompass the majority of price action, but not all. After sharp moves, penetration of the bands is normal. If prices appear to penetrate the outer bands too often, then a longer moving average may be required. If prices rarely touch the outer bands, then a shorter moving average may be required.
A more exact method to determine moving average length is by matching it with a reaction low after a bottom. For a bottom to form and a downtrend to reverse, a security needs to form a low that is higher than the previous low. Properly set Bollinger Bands should hold support established by the second (higher) low. If the second low penetrates the lower band, then the moving average is too short. If the second low remains above the lower band, then the moving average is too long. The same logic can be applied to peaks and reaction rallies. The upper band should mark resistance for the first reaction rally after a peak.
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For Wal-Mart (WMT), a 20-period simple moving average proved to be a bit too long for the Bollinger Bands. Notice the wide gap between the lower band and the higher low in March (see top SharpChart). Through trial and error, a 12-period simple moving average appears to offer a better fit (see bottom SharpChart).
For general time frames, Bollinger recommends a 10-day simple moving average for the short term, a 20-day simple moving average for the intermediate term and 50-day simple moving average for the long term.
UseIn addition to identifying relative price levels and volatility, Bollinger Bands can be combined with price action and other indicators to generate signals and foreshadow significant moves.
Double bottom Buy: A Double Bottom Buy signal is given when prices penetrate the lower band and remain above the lower band after a subsequent low forms. Either low can be higher or lower than the other. The important thing is that the second low remains above the lower band. The bullish setup is confirmed when the price moves above the middle band, or simple moving average.
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AT&T (T) provides an example of a Double Bottom Buy signal. The stock penetrated the lower band in late September (red arrow) and then held above on the subsequent test in October. The October breakout above the middle band (green circle) provided the bullish confirmation.
Double Top Sell: A Double Top Sell signal is given when prices peak above the upper band and a subsequent peak fails to break above the upper band. The bearish setup is confirmed when prices decline below the middle band.
Sharp price changes can occur after the bands have tightened and volatility is low. In this instance, Bollinger Bands do not give any hint as to the future direction of prices. Direction must be determined using other indicators and aspects of technical analysis. Many securities go through periods of high volatility followed by periods of low volatility. Using Bollinger Bands, these periods can be easily identified with a visual assessment. Tight bands indicate low volatility and wide bands indicate high volatility. Volatility can be important for options players because options prices will be cheaper when volatility is low.
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Starbucks (SBUX) provides an example of the bands tightening before a big move. In November, the bands were relatively wide and began to tighten over the next 2 months. By early January, the bands were the tightest in over 4 months (red circle). A little over a week later, the stock exploded for a 10+ point gain in less than 2 weeks.
Bollinger Bands and SharpChartshttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/bollinger_bands/BBtable.png
As a SharpCharts indicator, Bollinger Bands can be found in the Overlays section of the page. The first number in the Parameter text box sets the number of days for the simple moving average, which is the middle band. The second number sets the number of standard deviations for the upper and lower bands. The default setting is a 20-day simple moving average with the upper and lower bands set 2 standard deviations above and below. Both settings can be changed and users are encouraged to experiment.
Note: Sometimes when using the log scale, the lower band will exceed the price scale and become cut off. To alleviate this, change the scale setting from "log" to "linear."
DACLNIMY]Click here to see a live example of Bollinger Bands.
ConclusionsEven though Bollinger Bands can help generate buy and sell signals, they are not designed to determine the future direction of a security. The bands were designed to augment other analysis techniques and indicators. By themselves, Bollinger Bands serve two primary functions:
To identify periods of high and low volatility
[*]To identify periods when prices are at extreme, and possibly unsustainable, levels.
As stated above, securities can fluctuate between periods of high volatility and low volatility. Being able to identify a period of low volatility can serve as an alert to monitor the price action of a security. Other aspects of technical analysis, such as momentum, moving averages and retracements, can then be employed to help determine the direction of the potential breakout.
Remember that buy and sell signals are not given when prices reach the upper or lower bands. Such levels merely indicate that prices are high or low on a relative basis. A security can become overbought or oversold for an extended period of time. Knowing whether or not prices are high or low on a relative basis can enhance our interpretation of other indicators, and it can assist with timing issues in trading.
Keltner ChannelsKeltner Channels are a set of three lines that are overlaid on top of the price bars of a chart. As with other channel overlays, the outer two lines define a region that generally "contains" the price action and helps you determine if the prices are "too high" or "too low" relative to a specified moving average. Here is an example:
http://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/ibmkeltnerexample.png
In the chart above, the Keltner Channels are the thin blue lines above and below the candlesticks on the chart. The red line corresponds to the 20-day Exponential Moving Average that defines the center of the channel. Notice that the candles generally appear to "bounce" off the blue channel lines are return to the red central line.
HistoryThe original version of Keltner Channels was described by Chester W. Keltner in his 1960 book How to Make Money in Commodities. Keltner called his channel concept the "Ten-Day Moving Average Trading Rule" and defined it as a pair of lines positioned above and below a 10-day simple moving average of the chart's "typical price" - i.e., ( high + low + close ) / 3. The distance between the channel lines and the central line was defined as the 10-day simple moving average of the chart's "range" - i.e., high - low.
This original version of Keltner Channels was relatively easy to calculate in the days before computers and worked pretty well for trading commodities. As time passed, other channel systems - such as Bollinger Bands - became more popular. In the 1980s, Linda Raschke introduced a newer version of Keltner Channels that was based on the Exponential Moving Average and the Average True Range (ATR) indicator. StockCharts.com uses this more modern version of Keltner Channels.
FormulaIn the modern version of Keltner Channels, the central line is (typically) a 20-period Exponential Moving Average. The upper and lower bands are drawn at an equal distance from the central line. The distance is defined as a specified multiple (typically 2x) of the ATR(10) indicator.
In SharpCharts, the Keltner Channels take three parameters. The first one is the period of the central EMA. The second one is the multiplier for the bands. The last one is the period of the ATR indicator. The default parameter values are "20,2.0,10".
In the chart above, we've added the ATR(10) indicator below the price plot. You can see how the Keltner Channel expands as the ATR(10) value rises and contracts when it shrinks.
Note: Sometimes when using Keltner Channels on a log scale chart, the lower band will exceed the price scale and become cut off. To alleviate this, change the scale setting from "log" to "linear."
Moving Average Envelopes
IntroductionA simple moving average line can be enhanced by surrounding the line pattern with parallel envelopes. These envelopes deviate from the the moving average line by a user-specified percentage in order to determine when prices have strayed from the moving average line by that percentage. For example, charting 3% envelopes would display an upper parallel line that is 3% above the MA line, and a lower parallel line that is 3% below the MA line.
Examplehttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/ma_env/MAEnvelopes-csco_000.png
The chart for Cisco (CSCO)http://stockcharts.com/images/minilink_sc.gif shows 3% envelopes placed around a 20-day moving average of the security. Notice how during the downtrend the upper envelope was never touched, while the lower envelope was touched repeatedly.
Moves outside of the 3% envelopes are significant for short term traders who are more concerned with smaller price fluctuations. A short term analysis would see prices outside of the 3% envelopes as overextended. On the other hand, a long range analysis might focus on prices outside of 5% or 10% envelopes that surround a 10-week or 40-week average.
Moving Average Envelopes and SharpChartshttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/ma_env/MAEnvelopes-table_000.gif
With SharpCharts, moving average envelopes can be plotted as a price overlay. The first parameter specifies the number of periods for the moving average (default 20), and the second parameter sets the percentage difference between the envelopes and the moving average line (default 2.5).
Parabolic SAR
IntroductionDeveloped by Welles Wilder, creator of RSI and DMI, the Parabolic SAR sets trailing price stops for long or short positions. Also referred to as the stop-and-reversal indicator (SAR stands for "stop and reversal"), Parabolic SAR is more popular for setting stops than for establishing direction or trend. Wilder recommended establishing the trend first, and then trading with Parabolic SAR in the direction of the trend. If the trend is up, buy when the indicator moves below the price. If the trend is down, sell when the indicator moves above the price.
CalculationThe formula is quite complex and beyond the scope of this definition, but interpretation is relatively straightforward. The dotted lines below the price establish the trailing stop for a long position and the lines above establish the trailing stop for a short position. At the beginning of the move, the Parabolic SAR will provide a greater cushion between the price and the trailing stop. As the move gets underway, the distance between the price and the indicator will shrink, thus making for a tighter stop-loss as the price moves in a favorable direction.
There are two variables: the step and the maximum step. The higher the step is set, the more sensitive the indicator will be to price changes. If the step is set too high, the indicator will fluctuate above and below the price too often, making interpretation difficult. The maximum step controls the adjustment of the SAR as the price moves. The lower the maximum step is set, the further the trailing stop will be from the price. Wilder recommends setting the step at .02 and the maximum step at .20.
Examplehttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/parabolic_sar/ParabolicSAR-msft_000.png
The chart for Microsoft (MSFT)http://stockcharts.com/images/minilink_sc.gif shows how the Parabolic SAR can catch most trends and allow the trader to profit from the buy/sell signals. The default settings that Wilder recommends diminishes distracting fluctuations, but does not make the indicator immune to whipsaws (black arrow). A proper interpretation of this indicator would suggest that a trader should close long positions when the price falls below the SAR (red arrow) and close short positions when the price rises above the SAR (green arrow).
The Parabolic SAR works best during strong trending periods, which Wilder himself estimates occur roughly 30% of the time. Therefore, the user may first want to determine if the market is trending by using other indicators such as Wilder's ADX line.
Parabolic SAR and SharpChartshttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/parabolic_sar/parabolicsartable.gif
With SharpCharts, the Parabolic SAR can be charting using any specified step (first parameter) and maximum step (second parameter). Wilder's recommended parameters are used as default.
Click to see a live example of the Parabolic SAR
Price Channels
IntroductionSimilar to Bollinger Bands, price channels form boundaries above and below the price line and can be used as indicators of volatility. Price channels are created by specifying a number of periods that will chart an n-period high or low around the price line. For example, a 20-day price channel will chart the level of the highest high in the last 20 days above the price line, and will chart the level of the lowest low in the last 20 days below the price line. If the most recent price is a new n-period high or low, it will be charted outside of the price channel. Price channels differ from Bollinger Bands in that they use maximum and minimum price values instead of moving averages as boundaries.
Price channels can be used on daily, weekly, or monthly charts and can generate buy/sell signals at points of breakouts. When the price line breaks above or below the upper or lower price channel respectively, a new high or low becomes present. When the price breaks above a 20-day price channel, the price has reached a 20-day high and could potentially begin an uptrend. In this situation, the upper price channel breakout may signify that it is a good time to buy the stock.
Examplehttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/price_channels/PriceChannels-IBM_000.png
This chart for IBMhttp://stockcharts.com/images/minilink_sc.gif illustrates a lower channel breakout (red arrow) followed by a downtrend. This new 20-day low represented a good time to sell the security, and the signal was not reversed until the price line crossed the upper price channel on June 9.
Price Channels and SharpChartshttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/price_channels/PriceChannels-table_000.gif
With SharpCharts, a user can choose the length of the period for price channels. The larger the period, the more significant the channel breakouts and the more significant the signals. The second parameter (optional) allows the user to offset the price channel to the left or right. Placing a 10 in the second box will shift the price channels to the right 10 periods.
Volume by Price
Introduction"Volume by Price" is a horizontal histogram that overlays a price chart. The histogram bars stretch from left to right starting at the left side of the chart. The length of each bar is determined by the cumulative total of all volume bars for the periods during which the closing price fell within the vertical range of the histogram bar. Example
In the chart below, each volume-by-price bar covers a vertical range of 5 points. The longest bar covers the range from 27.5 to 32.5. The length of that bar was determined by adding up all of the volume bars on the days during which the price closed anywhere between 27.5 and 32.5.
http://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/price_by_volume/PBV-csco_000.png
Volume by Price and SharpChartshttp://stockcharts.com/school/data/media/chart_school/technical_indicators_and_overlays/price_by_volume/PBVtable.gif
Volume by Price can be selected as the "Volume By Price" overlay in SharpCharts. It takes no parameters.
Note: On SharpCharts, if the "Colored Bars" check box is checked, the volume-by-price bars will be split into two colors. The first color shows the total volume on days when the price moved