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Fundamental Analysis

Fundamental analysis is a method used to evaluate a security (in this case, stocks) to measure its intrinsic value (true value). It involves studying everything that can affect the value of the security including macroeconomic factors (i.e. overall economy and industry conditions) and company specific (i.e. financial conditions, management). The end-goal is to compare the intrinsic value vis-a-vis current market price and determine whether it is under-priced = buy, or overpriced = sell.

Topics:

  1. A stock price does not fully reflect a stock’s intrinsic value (true value) and
  2. the stock market will reflect the fundamentals in the long run.

However, the questions that persist in this type of analysis are (1) Will the stock reflect its intrinsic value? If so, (2) how long until It does?

Financial Statements are used as evaluation tools

  • Used to determine value by focusing on underlying factors that affect a company’s actual business and its future prospects.
  • Types of evaluation: Quantitative and Qualitative
    • Quantitative refers to numeric, measurable characteristics about a business
    • Qualitative refers to less tangible factors relating to quality or character such as board members and key executives, brand-name recognition, patents and or proprietary technology. Qualitative evaluation can apply to the Company or the Industry

The Company

  • Business Model: What does the company do?
  • Competitive Advantage: Does the company have a Unique competitive position, Sustainable and Efficient operations?
  • Management: Can the business model be properly executed?

An investor can look up these information from Annual Stockholders Meetings, Quarterly Briefings, Management Discussion and Analysis (found in quarterly or annual Financial Statements). It is also important to look into Past Performance and the company’s ability to provide Financial and Information Transparency.

  • A snapshot of a company’s health – how much a company owns (Assets), how much it owes (Liabilities). The difference between what it owns and what it owes is its Shareholder’s Equity (also known as Net Assets).

Assets = Liabilities + Shareholders’ Equity

Assets are resources that the business owns or controls at a given point in time. Includes items such as cash, inventory, machinery and buildings.

Liabilities + Shareholders’ Equity is the total value of the financing the company has used to acquire those assets. Liabilities represent debt (which of course must be paid back), while Equity represents the total value of money that the owners have contributed to the business, including Retained Earnings (profit made in previous years).

Assets are classified into Current Assets and Non-Current

Current Assets are likely to be used up or converted into cash within one business cycle (usually 12 months). Three very important current asset items found on the balance sheet are: Cash, Inventories and Accounts Receivables.

  • Cash offers protection against tough times and provides more options for future growth. Growing cash reserves often signal strong company performance while a dwindling cash pile could be a sign of trouble. However, if plenty cash becomes a permanent feature in the balance sheet, Investors need to ask why the money is not being put to use. Has the management run out of investment opportunities or is too short-sighted to know what to do with the money?
  • Inventories are finished products that haven’t yet sold. Companies have limited funds available to invest in inventory. To generate the cash to pay bills and return a profit, they must sell the merchandise they have purchased from suppliers. Inventory turnover (cost of goods sold divided by average inventory) measures how quickly the company is moving merchandise through the warehouse to customers. If inventory grows faster than sales, it is almost always a sign of deteriorating fundamentals.
  • Receivables are outstanding (uncollected bills). You can tell financial efficiency by how fast a company can collect what it is owed. If a company’s collection period is growing longer, it could mean problems ahead. The company may be letting customers stretch their credit in order to recognize greater top-line sales but can spell trouble later on, especially if customers face a cash crunch. The quicker a company gets its customers to make payments, the sooner it has cash to pay for salaries, merchandise, equipment, loans, and best of all, dividends and growth opportunities.

Non-Current Assets are anything not classified as a Current Asset. This includes items that are fixed assets, such as property, plant and equipment (PP&E). Unless the company is in financial distress and is liquidating assets, investors need not pay too much attention to fixed assets. Since companies are often unable to sell their fixed assets within any reasonable amount of time they are carried on the balance sheet at cost regardless of their actual value. As a result, it’s is possible for companies to grossly inflate this number, leaving investors with questionable and hard-to-compare asset figures.

Liabilities + Shareholders’ Equity is the total value of the financing the company has used to acquire those assets. Liabilities represent debt (which of course must be paid back), while Equity represents the total value of money that the owners have contributed to the business, including Retained Earnings (profit made in previous years).

Liabilities

Liabilities are classified into two Current and Non-Current Liabilities.

Current Liabilities are obligations the firm must pay within a year, such as payments owing to suppliers.

Non-current Liabilities represent what the company owes in a year or more time. Typically, non-current liabilities represent bank and bondholder debt.

Look for a manageable amount of debt. Generally speaking, if a company has more assets than liabilities, then it is in decent condition. By contrast, a company with a large amount of liabilities relative to assets ought to be examined with more diligence. Having too much debt relative to cash flows required to pay for interest and debt repayments is one way a company can go bankrupt.

Quick Ratio: Subtract inventory from current assets and then divide by current liabilities. If the ratio is 1 or higher, it says that the company has enough cash and liquid assets to cover its short-term debt obligations.

Current Assets – Inventories
Quick Ratio =————————————-
Current Liabilities

Shareholder’s Equity represents what shareholders own. It is computed as total assets minus total liabilities.

Shareholder’s Equity = Total Assets – Total Liabilities

The two important equity items are Paid-in Capital and Retained Earnings.

Paid-in capital is the amount of money shareholders paid for their shares when the stock was first offered to the public. It basically represents how much money the firm received when it sold its shares.

Retained Earnings are a tally of the money the company has chosen to reinvest in the business rather than pay to shareholders. Investors should look closely at how a company puts retained capital to use and how a company generates a return on it.

Considerations

Some assets and debt obligations are not disclosed in the Balance Sheet.

Companies often possess Hard-to-measure Intangible Assets. Corporate intellectual property (items such as patents, trademarks, copyrights and business methodologies), goodwill and brand recognition are all common assets that are not listed on company’s balance sheets.

Off-balance sheet debt is a form of financing in which large capital expenditures are kept off of a company’s balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep the debt levels low.

  • A record of a business’ cash inflows and outflows over a period of time. Usually difficult to manipulate, some investors use this as a more conservative measure of a company’s performance.
    • Operating Cash Flow (OCF): Cash generated from day-to-day business operations
    • Cash from Investing (CFI): Cash used for investing in assets, as well as the proceeds from the sale of other businesses, equipment or long-term assets
    • Cash from financing (CFF): Cash paid or received from the issuing and borrowing of funds

Like an Income Statement, it records financial performance over a specified period. But unlike the Income Statement, the Cash Flow Statement does not use accrual accounting which requires a record of revenues and expenses when transactions occur, not when cash is exchanged. On the other hand, the Income Statement, often includes non-cash revenues or expenses, which the Cash Flow Statement does not include.

Because it shows how much actual cash a company has generated, the Cash Flow Statement shows how a company is able to pay for its operations and future growth.

Companies produce and consume cash in different ways so the Cash Flow Statement is divided into 3 sections: Cash Flows from Operations, Financing and Investing.

Cash Flows from Operating Activities shows how much cash comes from sales of the company’s goods and services, less the amount of cash needed to make and sell those goods and services. Investors tend to prefer companies that produce a net positive cash flow from operating activities. High growth companies, such as technology firms, tend to show negative cash flow from operations in their formative years.

Cash Flows from Investing Activities reflects the amount of cash the company has spent on capital expenditures, such as new equipment or anything else that needed to keep the business going. It also includes acquisitions of other businesses and monetary investments such as money market funds. You want to see a company re-invest capital in its business by at least the rate of depreciation expenses each year. If it doesn’t re-invest, it might show artificially high cash inflows in the current year which may not be sustainable.

Cash Flow From Financing Activities describes the goings-on of cash associated with outside financing activities. Typical sources of cash inflow would be cash raised by selling stock and bonds or by bank borrowings. Likewise, paying back a bank loan would show up as a use of cash flow, as would dividend payments and common stock repurchases.

Free Cash Flow (FCF) signals a company’s ability to pay debt, pay dividends, buy back stock and facilitate the growth of business. The excess cash produced by the company, can be returned to shareholders or invested in new growth opportunities without hurting the existing operations. A company’s ability to pay for its own operations and growth, without relying on outside financing, signals to investors that it has very strong fundamentals.

Net Income
+ Amortization/Depreciation
– Changes in Working Capital
– Capital Expenditures
—————————————-
= Free Cash Flow

Shows a company’s performance over a specific time (reported quarterly/annually). Shows how much money the company generated (Revenue), how much it spent (Expenses) and the difference between the two (Profit/Net Income/Earnings/Bottomline) as a result of the business’ operations for that period. Those companies with low expenses relative to Revenue – or high Profits/Earnings relative to Revenue – signal strong fundamentals to investors.

Revenues (also called the Topline) represents all the money a company brought in during a specific time period, although big companies sometimes break down revenue by business segment or geography. The best way for a company to improve profitability is by increasing sales revenue. Recurring Revenue (continue year in and out) are the best revenues while Temporary/One-time) gains are less valuable and should garner a lower price-to-earnings multiple for a company.

Expenses have 2 common types: Cost of Good Sold (COGS) and Selling, General and Administrative Expenses (SG&A).

Cost of Goods Sold (COGS) represents the costs of producing or purchasing the goods or services sold by the company. This expense is directly involved in creating revenue.

Selling, General and Administrative Expenses (SG&A) includes marketing, salaries, utility bills, technology expenses and other general costs associated with running a business. SG&A also includes Depreciation and Amortization. Some corporate expenses, such as Research and Development (R&D) are crucial to future growth and should not be cut, even though doing so may make for a better-looking earnings report. Finally, there are Financial Costs, notably taxes and interest payments, which need to be considered.

Profits = Revenue – Expenses

There are several commonly used profit subcategories that tell investors how the company is performing.

Gross Profit = Revenue minus Cost of Sales.

Companies with high Gross Margins will have a lot of money left over to spend on other business operations, such as R&D or marketing. When cost of goods sold rises rapidly, they are likely to lower gross profit margins – unless, of course, the company can pass these costs onto customers in the form of higher prices.

Operating Profit = Revenues minus the Cost of sales and SG&A

Operating Profits represents the profit a company made from its actual operations, and excludes certain expenses and revenues that may not be related to its central operations. High Operating Margins can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Operating profit measures how much cash the business throws off, and some consider it a more reliable measure of profitability since it is harder to manipulate with accounting tricks than net earnings.

Net Income (also known as Earnings or Bottom line) represents the company’s profit after all expenses, including financial expenses, have been paid.

A high Profit Margin usually means that it also has one or more advantages over its competition and can mean a company has a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn. And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times – leaving them even better positioned when things improve again.

Note: Increasing Sales offers the first sign of strong fundamentals. Rising margins indicate increasing efficiency and profitability. It’s also a good idea to determine whether the company is performing in line with industry peers and competitors.

a.Management Discussion and Analysis (MD&A)

Provides a clearer picture of what the company does and points out key areas in which the company has performed well. Disclosure is the name of the game. A company must give sufficient and honest information about current operations, future prospects or potential risks or uncertainties and address serious problems.

Other useful and revealing documents are:

  • Auditor’s report (Report of Independent Accountants) scrutinizes the company and identify anything that might undermine the integrity of the financial statements
  • Notes to Financial Statements indicate Accounting Methods, Disclosures

  1. Management Discussion and Analysis (MD&A)

Provides a clearer picture of what the company does and points out key areas in which the company has performed well. Disclosure is the name of the game. A company must give sufficient and honest information about current operations, future prospects or potential risks or uncertainties and address serious problems.

Other useful and revealing documents are:

  • Auditor’s report (Report of Independent Accountants) scrutinizes the company and identify anything that might undermine the integrity of the financial statements
  • Notes to Financial Statements indicate Accounting Methods, Disclosures
  1. Discounted Cash Flow (DCF)
  2. Ratio Valuation
    • Earning Per Share (EPS), Diluted EPS, Price-to-Earnings (P/E ratio or PER), Price/Earnings to Growth Ratio (PEG), Book Value (BV), Price-to-Book Value (PBV), Dividend, Dividend Yield, Return on Assets (ROA), Return on Equity (ROE)

Discounted Cash Flow (DCF) Method uses the premise that the current value of a company is simply the present value of its future cash flows that are attributable to shareholders.

DCF = CF1 + CF2 + … CFn
—— ————
(1+r)1 (1+r)2(1+r)n
CF = Cash Flow
r = Discount Rate (WACC)

Simply explained, if we know a company will generate per share in cash flow for shareholders every year into the future; we can calculate what this type of cash flow is worth today. This value is then compared to the current value of the company to determine whether the company is a good investment, undervalued (indicates a buy) or overvalued (indicates a sell).

Several different techniques essentially differ on what type of cash flow is used in the analysis. The Dividend Discount Model focuses on the dividends the company pays to shareholders. The Cash Flow Model looks at the cash that can be paid to shareholders after all expenses, reinvestments and debt repayments have been made. Conceptually they are the same, as it is the present value of these streams that are taken into consideration.

Note: The challenge lies in the implementation of the model as there are a considerable amount of estimates and assumptions that go into the model like forecasting the revenue and expenses for a firm 5 or 10 years into the future can be considerably difficult.

Financial ratios are mathematical calculations using figures mainly from the financial statements, and are used to gain an idea of a company’s valuation and financial performance.

Earning Per Share (EPS) = Net Earnings / Outstanding Common Shares. Indicates a company’s profitability. Net Earnings can either be the last 12 months (trailing 12 months) or expected next 12 months. Diluted EPS includes the shares of convertibles or warrants outstanding in the outstanding shares number. Note that it is more accurate to use a weighted average number of shares outstanding over the reporting term, because the number of shares outstanding can change over time.

Price-to-Earnings (P/E ratio or PER) = Price / EPS. It is the most widely reported and used valuation. Also referred to as a Multiple, it shows how much investors are willing to pay per peso of earnings. If a company were currently trading at a multiple (P/E) of 15, the interpretation is that an investor is willing to pay Php10 for Php1 of current earnings.

Generally a high P/E ratio means that investors are anticipating higher growth in the future. Generally an attractive P/E ratio is 10x or lower, while 15x is considered the historical average. However, the standard of the ratio will also vary widely among different companies and industries. The P/E ratio can use estimated earnings to get the forward looking P/E ratio. Companies that are losing money do not have a P/E ratio.

Price/Earnings to Growth Ratio (PEG) is a refinement of the P/E ratio and factors in a stock’s estimated earnings growth into its current valuation. By comparing a stock’s P/E ratio with its projected, or estimated, earnings per share (EPS) growth, investors are given insight into the degree of overpricing or underpricing of a stock’s current valuation, as indicated by the traditional P/E ratio.

PEG Ratio = P/E Ratio
————-
EPS Growth

The assumption with high P/E stocks (generally of the growth variety) is that investors are willing to buy at a high price because they believe that the stock has significant growth potential. The PEG ratio helps investors determine the degree of reliability of that growth assumption.

Book Value (BV) is the value of a company’s assets expressed on the balance sheet. It is the difference between the balance sheet assets and balance sheet liabilities and is an estimation of the value if it were to be liquidated.

Price-to-Book Value (PBV) = Price / Book Value. An indication of how much shareholders are paying for the net assets of a company. Companies trading below ‘1’ are considered undervalued.

Note: Valuation ratios are also compared to the historical values of the ratio for the company, along with comparisons to competitors and the overall market itself.

Dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. It is most often quoted in terms of the peso amount each share receives (Dividends per Share). Note that some companies may or may not have a declared dividend policy and despite having one, has the option to issue or not in a particular year.

  • Dividends can come in the form of Cash, Stock or Property
  • Regular or Special (non-recurring, also called as “extra dividend,” usually declared when a company).
  • Declaration Date, Record Date, Ex-date and Payment Date. The most important date to note is the Ex-date (a date that comes before the Record Date). An investor must own a stock a day before Ex-date to avail of the Dividend. On the Ex-date or after, the investor has the option to sell his stock and still be entitled to the dividend. On the Ex-date, the stock price usually drops approximately by the amount of the dividend to factor in that the company is paying out a part of its profits (reducing its cash).

Most secure and stable companies offer dividends to their stockholders. In some cases, their share prices might not move much, but the dividend attempts to make up for this. High-growth companies rarely offer dividends because all of their profits are reinvested to help sustain higher-than-average growth.

Dividend Yield is expressed as an annual percentage and is calculated as the company’s annual cash dividend per share divided by the current price of the stock.

Dividend Yield = Annual Dividend per Share
—————————————
Stock Price per Share

Note: When investing in equities, a shareholder earns from the dividend and capital appreciation (when a stock price appreciates from the acquisition cost).

Return on Assets (ROA) illustrates how well management is employing the company’s total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base.

Return on Assets = Net Income
——————————-
Average Total Assets

Return on Equity (ROE)measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.

Return on Equity = Net Income
——————————-
Average Shareholder’s Equity

You can find net income on the income statement, and Assets and Shareholders’ Equity appears in the Balance sheet.

Both ROA and ROE gauge a company’s ability to generate earnings from its investments. If ROA is sound and debt levels are reasonable, a strong ROE is a solid signal that managers are doing a good job of generating returns from shareholders’ investments. On the other hand, if ROA is low or the company is carrying a lot of debt, a high ROE can give investors a false impression about the company’s fortunes.

The big factor that separates ROE and ROA is financial leverage, or debt. If a company carries no debt, its shareholders’ equity and its total assets will be the same. It follows then that their ROE and ROA would also be the same. But if that company takes on financial leverage (debt), ROE would rise above ROA.

Remember that Assets = Liabilities + Shareholders’ Equity

The equation is also expressed as Shareholders’ Equity = Assets – Liabilities.

By taking on Debt, a company increases its Assets thanks to the cash that comes in. But the company in turn also decreases its Equity by increasing Debt. In other words, when Debt increases, Equity shrinks, and since Equity is the ROE’s denominator, ROE, in turn, gets a boost. At the same time, when a company takes on Debt, Assets (the denominator of ROA) increases. So, Debt amplifies ROE in relation to ROA.

Because ROE weighs net income only against owners’ equity, it doesn’t say much about how well a company uses its financing from borrowing and bonds. Such a company may deliver an impressive ROE without actually being more effective at using the shareholders’ equity to grow the company. ROA – because its denominator includes both debt and equity – can help you see how well a company puts both these forms of financing to use.


Technical Analysis

While Fundamental Analysis helps the investor determine the What and the Why. Technical Analysis answers the When. Technical Analysis is forecasting future price movement based on past price movements. While it is not an absolute science, it studies market psychology to anticipate what is likely to happen through a graphic representation. This type of analysis can be applied to index, sector and individual stocks.

Topics:

While Fundamental Analysis helps the investor determine the What and the Why. Technical Analysis answers the When.

Technical Analysis is forecasting future price movement based on past price movements. While it is not an absolute science, it studies market psychology to anticipate what is likely to happen through a graphic representation. This type of analysis can be applied to index, sector and individual stocks.

Basic Assumptions

Different types of charts are the Bar chart, Line chart, Point and Figure charts and the popular Japanese Candlesticks.

A chart graphically represents a series of prices over a set period of time. While the period can vary from seconds to decades, the more frequently used time scales are intraday, daily, weekly, monthly, quarterly and annually. For a longer term perspective, chartists use the multi-year chart such as the 5-year and 10-year charts

A trend in motion will tend to remain in motion.

Market moves are made up of a series of zigzags (composed of peaks and troughs) that move in a certain direction. An Uptrend is a series of successively higher peaks and troughs. A Downtrend is the inverse – a series of declining peaks and troughs. A Sideways trend is a series of horizontal peaks and troughs.

A Trend has three directions: Up, Down and Sideways or also called a Trading Range. A trader would go long (buy) in an uptrend, go short (sell) on a downtrend or stay on the sidelines on a sideways/flat market. More adept traders can decide to Trade the Range in a Sideways market assuming he has established a range and protective stops in the case the market turns towards another direction – whether up or down.

A Trend generally has three classifications: Major (in effect for longer than a year), Intermediate (about 3 weeks to as many months) and Near-term (usually less than 2 or 3 weeks). Each trend is a part of a larger trend as much as it is comprised of smaller trends. For example, a corrective Intermediate trend could be a pullback of an upward Major trend.

Support and Resistance & Role-Reversal A Support is under a current price/level where the buying interest is sufficiently strong to overcome the selling pressure. In effect, the decline is halted and prices turn back up again. Usually a support is identified by a previous reaction low.

A Resistance is the opposite, it is over a current price/level where selling pressure overcomes buying pressure and a price advance is turned back. Usually, a resistance is identified by a previous peak.

Supports and Resistances are pauses in a Downtrend or Uptrend, respectively. They can either be exceeded or maintained.

In an uptrend, each successive low (Support level) must be higher than the one preceding it and each rally high (Resistance) must be higher than the one before it. However, if a corrective dip in an uptrend retests the previous low, it may be an early signal that the uptrend is ending or at least moving from an uptrend to a sideways trend. If a Support level is violated then a trend reversal is likely. In the case that a Support/Resistance is penetrated by a significant amount, they reverse their roles. The previous resistance which is now under the market becomes a support. Or the previous Support which is now over the market becomes a Resistance.

Support becomes Resistance Significance of a Support/Resistance is increased if (1) prices trade in that level for a longer period of time, (2) the volume is higher and (3) the more recent the trading took place.

To explain how a support level works in an uptrend: Think of the investors who are long (who bought near the support and are delighted to see that prices are higher from their cost), and the uncommitted (ones who sold too early and want to reposition or ones who are still waiting to buy). Investors who are long whose purchase was validated with the continued uptrend may want to add to their existing position on a pullback to the same support level; while the uncommitted have either resolved to either buy back or initiate a position at the same support level believing that the uptrend will continue. All these groups will be interested to buy at the same support level, and if prices do decline to that support or nearby, renewed buying will push prices up form that support level, making it more significant.

Fibonacci Retracement

Discovered in the 13th century by Leonardo Fibonacci, the Fibonacci sequence is simply the sum of the two preceding terms (1, 1, 2, 3, 5, 8, 13, etc.). However, what is more important is the quotient of the adjacent terms that possesses an amazing proportion, roughly 1.618, or its inverse 0.618. It has been called ? (phi), the Golden Mean or the Divine Ratio because it seems to have a fundamental function from nature to architecture to finance.

This tool is popular because it clearly identifies levels of potential support/resistance. Notice in the chart above how identified levels (dotted lines) are barriers to the short-term direction of the price.

Typically used are the 38.2%, 50% and 61.80%; however, more multiples can be used as needed, 0%, 23.6%, 100%, 123.6% and so on. This can also be used to draw arcs, fans and time zones.

Round Numbers

Round Numbers usually act as psychological Support and Resistance levels such as 1, 5, 10, 15 … 100 (and multiples of 1,000) which stop advances or declines. In practical application, a trader should avoid placing orders at these obvious round numbers. This can also apply to protective stops. For example, if a trader wants to buy into a short term market dip, it would make more sense to place limit orders just above the important round number; inversely, traders looking to sell on a bounce, should place sell orders just below the round number. In some cases, although these round numbers are hit, they do not represent much of the volume traded for the period.

Trendlines & Role Reversal

A Trendline adds a line to a chart to represent the general trend in the market or a stock. An up trendline is a straight line drawn upward to the right along successive reaction lows. A down trendline is drawn downward to the right along successive rally peaks.

In drawing a Trendline, as in drawing a line, the trader must be able to connect 2 points – 2 successive reaction lows (in an uptrend) or 2 successive rally peaks (downtrend). But only if prices move higher or lower, respectively, on the third point is the chartist reasonably confident that a reaction low has been formed. The trader can then make projections on price movements using the Trendline.

While a Trend in motion will tend to remain in motion, it can also be said that once a Trend assumes a certain slope or rate of speed, as identified by a Trendline, it will usually maintain the same slope. The Trendline helps determine extremities of corrective phases and can even signal when a trend is changing.

Like a Support and Resistance level, a Trendline becomes more significant the longer it has been intact and the more times it has been tested.

It is good to draw a Trendline along the closing prices as much as the low prices (which factors in all action). However, there are no hard and fast rules, so a minor breach of the trendline can be considered “noise” and ignored.

A trendline can reverse its role. An up trend line (a support line) will usually become a resistance line once its decisively broken. Inversely, a down trendline (a resistance line) will often become a support line once it’s decisively broken.

Channels

Also known as the Return line, a Channel line is the addition of two parallel Trendlines that act as strong areas of support and resistance.

Drawing a Channel in an up Trendline involves the basic Trendline along the lows. Then, a parallel line is drawn along the peaks. The inverse would apply to a down Trendline.

Just like a basic Trendline, the longer the Channel remains intact and the more often it’s successfully tested, the more significant and reliable it is.

In the case of a broken Channel, this could signify an acceleration of the existing trend. Some traders view the clearing of the upper line in an uptrend as a reason to add to long positions. Another way to use the channel is to spot failure.

The Number 3

For some reason, the Number 3 shows up in the study of technical analysis and the important role it plays in many technical approaches. There are 3 major phases in both the Dow Theory and the Elliot Wave Theory, there are 3 trend directions and 3 trend classifications, 3 kinds of gaps, commonly known reversal patterns have three prominent peaks like the triple top and the head and shoulders, and among the generally accepted continuation patterns, there are 3 types of triangles (the symmetrical, ascending and descending).

In the local market for example, traders tend to follow the 3-day rule on short-term trades, wherein one can expect the peak (uptrend) or the trough (downtrend) of any move on the third day (intraday or not), prompting the trader to sell on the second day (to be conservative) or early on the third day on an uptrend or buy on the second day (if buying more than one unit or so as not to “miss the market”) or early on the third day.

Percentage Requirements

After a particular market move, prices retrace a portion of the previous trend before resuming in the original direction. These countertrend moves tend to fall into certain predictable % parameters. If a trader is looking to buy under the market, a 33-38% to 50% is a general frame of reference for buying opportunities. The maximum retracement area is 62-66% which becomes an especially critical area. While this becomes a relatively low-risk buying or selling area in a downtrend, if prices move beyond this the point, the odds will stack towards a trend reversal than just a retracement. If so, the move can retrace the entire 100% of the prior trend.

This approach is used in the Dow Theory, Elliot Wave & Fibonacci.

Reversal Days

Also called the Top Reversal Day/Buying Climax, Bottom Reversal Day/Selling Climax, and the Key Reversal Day. It takes place either at a top or bottom.

Top Reversal Day is usually a new high in an uptrend, followed by a lower close on the same day. This means that prices set a new high (usually at or near the opening) then weaken and actually close lower than the previous day’s closing. This can be interpreted as sellers dominating buyers.

Bottom Reversal Day would be a new low during the day followed by a higher close on the same day. This is when all the discouraged longs have been forced out of the market on heavy volume and the subsequent absence of selling pressure allows prices to quickly rally. This can be interpreted as buyers dominating the sellers. While this may not mark the final bottom of a market, it may signal that a significant low has been seen.

The wider the range for the day and the heavier the volume, the more significant is the signal for a possible near term trend reversal. Note that both the high and the low on the reversal day exceed the range of the previous day, forming an outside day (when the high is above the previous day’s high and the low is below the previous day’s low). While not a requirement, the existence of an outside day carries more significance.

Weekly and Monthly Reversals show up on weekly and monthly charts, respectively. An Upside Weekly Reversal would occur when the market trades lower during the week, makes a new low for the move, but on Friday closes above the previous Friday’s close. Weekly reversals are much more significant than daily reversals. Meanwhile, monthly reversals are even more important.

Price Gaps

Areas on the bar chart where no trading has taken place. In an uptrend, prices open above the highest price of the previous day, leaving a gap or open space on the chart that is not filled during the day. In a downtrend, the day’s highest price is below the previous day’s low.

While upside gaps are signs of market strength, downside gaps are usually signs of weakness. Although commonly seen on day charts, on long-term weekly and monthly charts, they are usually very significant.

Although it is often said that “gaps are always filled,” it is not a hard and fast rule.

Different types of gaps have different forecasting implications depending on the type and when they occur. The three general types are the Breakaway, the Runaway (or Measuring Gap) and Exhaustion Gaps.

The Breakaway Gap usually signals an important market move. After a market has completed a major basing pattern, the breaking of resistance often occurs on a breakaway gap. Major breakouts from topping or basing areas are breeding grounds for this type of gap. The breaking of a major trendline, signaling a trend reversal, might also see a breakaway gap. More often, breakaway gaps are not filled, meaning prices may just return to to the upper end of the gap (in the case of a bullish breakout), or close just a portion of the gap, with another portion unfilled. Upside gaps usually act as support areas on subsequent market corrections. But when prices close below an upward gap, it is a sign of weakness.

The Runaway or Measuring Gap occurs somewhere around the middle of the move, prices will leap forward to form a second type of gap (or a series of gaps). In an uptrend, it’s a sign of market strength while in a downtrend, it’s a sign of market weakness. Runaway gaps act as support under the market on subsequent corrections and are often not filled. But like in the Breakaway Gap, when prices move below the runaway gap, it is a negative sign in an uptrend. Because it usually occurs mid-way of a move, a trader can estimate the probable extent of the move by doubling the amount already achieved.

The Exhaustion Gap appears near the end of a market move. After the two types of gaps have been achieved, the trader must expect the Exhaustion Gap. Near the end of an uptrend, prices leap forward in a last gap. However that upward leap quickly fades and prices turn lower within a couple of days or within a week. When prices close under the last gap, it is usually a dead giveaway that the exhaustion gap has made its appearance. This would also work in a downtrend that has finally reached its trough.

The Island Reversal is when prices trade in a narrow range for a couple of days or weeks before gapping to the downside. The few days/weeks of price action then looks like an “island” surrounded by a space or water. This combination of gaps usually signals an important reversal.

Long Term Charts

While the daily bar chart is the most popular tool used in forecasting, the use of weekly and monthly charts for longer range trend analysis and forecasting is very useful and rewarding. Long term charts manage to compress more action providing a larger perspective on the market.

Price patterns may appear to be more prominent such as Double Tops and Bottoms or the Head and Shoulder Reversals. Triangles, which are usually continuation patterns, are frequently seen. A trader will also be able to spot Weekly and Monthly Reversals using this.

In chart analysis is best to begin with the long range and gradually work to the near term. Once the analyst knows where the market is from a longer range perspective, the analyst can “zero in” on the shorter term saving the trouble of constantly revising conclusions as more price data is considered.

Long term charts are useful in the analytical process to help determine the major trend and price objectives. For timing an entry and exit, daily and intraday charts are best used.

Confirmation and Divergence

Confirmation refers to the comparison of all technical signals and indicators to ensure the most of these indicators are pointing in the same direction and are confirming one another.

Divergence is the opposite of confirmation and refers to a situation where different technical indicators fail to confirm one another. Divergence is a valuable concept in market analysis, and one of the best early warning signals of impending trend reversals.

Confirmation and Divergence

Price patterns are pictures or formations on charts that have predictive value.

Two major types of patterns are Reversal and Continuation. While Reversal Patterns indicate a reversal in trend taking place, Continuation Patterns, suggest that the market is only pausing for a while, possibly to correct a near term overbought or oversold condition, after which the existing trend will be resumed.

Most price patterns also have certain measuring techniques to determine minimum price objectives, thus, assists in determining risk-reward ratio. Note that the maximum objective would be the total extent of the prior move, or the point at which it all began.

Preliminary points common to all reversal patterns:

  1. The existence of a prior trend.
  2. The first signal of an impending trend reversal is often the breaking of an important trendline.
  3. The larger the pattern, the greater the subsequent move. This refers to the height (measures volatility) and the width (amount of time required to build and complete the pattern).
  4. Topping patterns are usually shorter in duration and more volatile than bottoms.
  5. Bottoms usually have smaller price ranges and take longer to build.
  6. Volume is usually more important on the upside. Volume should generally increase in the direction of the market trend and is an important confirming factor in the completion of all price patterns. In a market top, volume is not as important, but at bottoms, the volume pick-up is absolutely essential. If the volume pattern does not show a significant price increase during the upside breakout, the entire price pattern should be questioned.

Some of the most commonly used major reversal patterns are the Head and Shoulders (I) and the Inverse Head and Shoulders (II), Double Top (III) and Double Bottom (IV), Triple Tops (V) and Triple Bottom (VI), Spike or V Tops (VII) and Spike or V Bottoms (VIII), Rounding Bottom or Saucer Pattern (IX), Falling Wedge (X) and the Rising Wedge (XI).

  1. Head & Shoulders Reversal (Bearish)

    The Head and Shoulders reversal pattern is made up of a left shoulder, a head, a right shoulder, and a neckline. Other parts playing a role in the pattern are volume, the breakout, price target and support turned resistance.

    1. There must be a Prior Trend to reverse. In this case, an uptrend.
    2. Left Shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder (1). The low of the decline usually remains above the trend line, keeping the uptrend intact.
    3. From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the Head. After peaking, the low of the subsequent decline marks the second point of the neckline (2). The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy.
    4. The advance from the low of the head forms the Right Shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, it not a strict requirement. The decline from the peak of the right shoulder should break the neckline.
    5. The Neckline forms by connecting low points 1 (end of left shoulder, beginning of the head) and 2 (end of the head and the beginning of the right shoulder). Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal. The slope of the neckline will affect the pattern’s degree of bearishness: a downward slope is more bearish than an upward slope. Sometimes more than one low point can be used to form the neckline.
    6. As the Head and Shoulders pattern unfolds, Volume plays an important role in confirmation. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. This decrease in volume and the new high of the head, together, serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final confirmation comes when volume further increases during the decline of the right shoulder.
    7. Neckline break completes the head and shoulders pattern and reverses the uptrend, usually in a convincing manner such as increased volume.
    8. Support Turned Resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break, and offer a second chance to sell.
    9. After breaking neckline support, the projected price decline (Price Target) is found by (1) measuring the distance from the neckline to the top of the head; (2) subtracting the figure from the neckline to reach a rough guide to a price target which can be used with other technical tools such as Fibonacci retracement, Moving Average, etc.
  2. Inverse Head & Shoulders Reversal (Bullish)

    The price action forming both Head and Shoulders Top and Head and Shoulders Bottom patterns remains roughly the same, but reversed. The role of volume marks the biggest difference between the two. Generally speaking, volume plays a larger role in bottom formations than top formations. While an increase in volume on the neckline breakout for a Head and Shoulders Top is welcomed, it is absolutely required for a bottom.

    Volume levels during the first half of the pattern are less important than in the second half. Volume on the decline of the left shoulder is usually pretty heavy and selling pressure quite intense. The intensity of selling can even continue during the decline that forms the low of the head. After this low, subsequent volume patterns should be watched carefully to look for expansion during the advances.

    The advance from the low of the head should show an increase in volume and/or better indicator readings. After the reaction high forms the second neckline point, the right shoulder’s decline should be accompanied with light volume. It is normal to experience profit-taking after an advance. Volume analysis helps distinguish between normal profit-taking and heavy selling pressure. With light volume on the pullback. The most important moment for volume occurs on the advance from the low of the right shoulder. For a breakout to be considered valid, there needs to be an expansion of volume on the advance and during the breakout.

  3. Double Top (Bearish)

    The pattern is made up of two consecutive peaks that are roughly equal, with a moderate trough in-between. Although there can be variations, the classic Double Top Reversal marks at least an intermediate change, if not a long-term change, in trend from bullish to bearish. Many potential Double Top Reversals can form along the way up, but until key support is broken, a reversal cannot be confirmed.

    1. There must be a Prior Trend to reverse. In the case of the Double Top Reversal, a significant uptrend of several months should be in place.
    2. The First Peak should mark the highest point of the current trend. As such, the first peak is fairly normal and the uptrend is not in jeopardy (or in question) at this time.
    3. After the first peak, a decline takes place that typically ranges from 10 to 20% called the Trough. Volume on the decline from the first peak is usually inconsequential. The lows are sometimes rounded or drawn out a bit, which can be a sign of tepid demand.
    4. The Second Peak occurs when the advance off the lows usually occurs with low volume and meets resistance from the previous high. Resistance from the previous high should be expected. Even after meeting resistance, only the possibility of a Double Top Reversal exists. The pattern still needs to be confirmed. The time period between peaks can vary from a few weeks to many months, with the norm being 1-3 months. While exact peaks are preferable, there is some leeway. Usually a peak within 3% of the previous high is adequate.
    5. The subsequent Decline from the Second Peak should witness an expansion in volume and/or an accelerated descent, perhaps marked with a gap or two. Such a decline shows that the forces of demand are weaker than supply and a support test is imminent.
    6. Even after trading down to support, the Double Top Reversal and trend reversal are still not complete. Breaking Support from the lowest point between the peaks completes the Double Top Reversal. This too should occur with an increase in volume and/or an accelerated descent.
    7. Broken support becomes Potential Resistance and there is sometimes a test of this newfound resistance level with a reaction rally. Such a test can offer a second chance to exit a position or initiate a short.
    8. The distance from support break to peak can be subtracted from the support break for a Price Target. This would infer that the bigger the formation is, the larger the potential decline.

    Avoid deceptive Double Top Reversals.

    1. The peaks should be separated by about a month. If the peaks are too close, they could just represent normal resistance rather than a lasting change in the supply/demand picture.
    2. Ensure that the low between the peaks declines at least 10%. Declines less than 10% may not be indicative of a significant increase in selling pressure. After the decline, analyze the trough for clues on the strength of demand. If the trough drags on a bit and has trouble moving back up, demand could be drying up.
    3. When the security does advance, look for a contraction in volume as a further indication of weakening demand.
    4. Wait for support to be broken in a convincing manner, and usually with an expansion of volume. A price filter might require a 3% support break before validation. A time filter might require the support break to hold for 3 days before considering it valid. The trend is in force until proven otherwise. This applies to the Double Top Reversal as well.
  4. Double Bottom (Bullish)

    The Double Bottom Reversal is the bullish reversal pattern counterpart of the Double Top. The pattern is made up of two consecutive troughs that are roughly equal, with a moderate peak in-between.

    This is an intermediate to long-term reversal pattern that will not form in a few days. Even though formation in a few weeks is possible, it is preferable to have at least 4 weeks between lows. Bottoms usually take longer than tops to form and patience can often be a virtue. Give the pattern time to develop and look for the proper clues. The advance off of the first trough should be 10-20%. The second trough should form a low within 3% of the previous low and volume on the ensuing advance should increase. Volume can be used to look for signs of buying pressure. Just as with the double top, it is paramount to wait for the resistance breakout. The formation is not complete until the previous reaction high is taken out.

  5. Triple Top (Bearish)

    The Triple Top Reversal is a bearish reversal pattern. There are three equal highs followed by a break below support. As major reversal patterns, these patterns usually form over a 3 to 6 month period.

    1. There should be a Prior Trend to reverse. In this case, an uptrend.
    2. All Three Highs should be reasonably equal, well spaced and mark clear turning points to establish resistance. The highs do not have to be exactly equal, but should be reasonably equivalent to each other.
    3. As the Triple Top Reversal develops, overall volume levels usually decline. Volume sometimes increases near the highs. After the third high, an expansion of volume on the subsequent decline and at the support break greatly reinforces the soundness of the pattern.
    4. The Triple Top Reversal is not complete until a Support Break. The lowest point of the formation, which would be the lowest of the intermittent lows, marks this key support level.
    5. Broken support becomes potential resistance, and there is sometimes a test of this newfound resistance level with a subsequent reaction rally.
    6. The distance from the support break to the highs can be measured and subtracted from the support break for a Price Target. The longer the pattern develops, the more significant the ultimate break. Triple Top Reversals that are 6 or more months old represent major tops and a price target is less likely to be effective.
    7. Throughout the development of the Triple Top Reversal, it can start to resemble a number of other patterns. Before the third high forms, the pattern may look like a Double Top Reversal. Three equal highs can also be found in an ascending triangle or rectangle. Of these patterns mentioned, only the ascending triangle has bullish overtones; the others are neutral until a break occurs. In this same vein, the Triple Top Reversal should also be treated as a neutral pattern until a breakdown occurs. The inability to break above resistance is bearish, but the bears have not won the battle until support is broken. Volume on the last decline off resistance can sometimes yield a clue. If there is a sharp increase in volume and momentum, then the chances of a support break increase.
  6. Triple Bottom (Bullish)

    The Triple Bottom Reversal is a bullish reversal pattern counterpart of the Triple Top. There are three equal lows followed by a break above resistance. As major reversal patterns, these patterns usually form over a 3 to 6 month period.

  7. Spike or V Top

    1. Uptrend: Look for price to make a straight-line run upward with few or no pauses, often fitting inside a channel (two parallel trendlines).
    2. Reversal: Price at the top of the inverted V will form a one-day reversal, island reversal, or tail, usually on heavy volume.
    3. After the reversal, price pierces an up-sloping trendline drawn along the price lows, confirming the trend change.
    4. Downtrend: Price trends down, usually at the mirror angle of the uptrend. If price climbed by 45 degrees, price will tumble following a 45 degree trend. The price trend tends to be a straight-line run with few or no pauses, often fitting inside a channel.

    Trading V tops is not an easy proposition. Draw a trendline along the bottoms as price rises in the first part of the V. When price pierces the trendline, then check for any fundamental news that would account for a reversal. Check other stocks in the same industry to see how they are behaving. Sometimes, one stock will pull the industry down with it. If you find no fundamental news and other stocks in the industry look good, then the turn may not be at hand. Wait for 3 days and if price continues declining, then sell. Of course, you can also sell once price closes below the trendline.

  8. Spike or V Bottom

    1. Downtrend: Look for price to make a straight-line run downward with few or no pauses, often fitting inside a channel.
    2. Reversal: Price at the bottom of the V will form a one-day reversal, island reversal, or tail, usually on heavy volume, perhaps gapping upward.
    3. After the reversal, price pierces a down-sloping trendline drawn along the price tops, confirming the trend change.
    4. Uptrend: Price trends up, usually at the mirror angle of the downtrend. If price dropped by 30 degrees, price will rise following a similar angle. The price trend tends to be a straight-line run with few or no pauses, often fitting inside a channel.

    Trading a V bottom is difficult because calling the turn at the bottom of the V is tough to do correctly. You can use a down trendline (drawn along the descending price tops leading to the V bottom) pierce as the buy signal but it’s best to wait 2 or 3 days for price to confirm the tend change. You can also check the mirror angle. Often price will rise in an angle similar to the descent. If that appears to be the case, then buy. Check other stocks in the same industry for a trend change. Usually the industry moves as a group and a reversal in one still will appear in other stocks in the industry as well.

  9. The Rounding Bottom or Saucer Pattern (Bullish)

    The Rounding Bottom is a long-term reversal pattern that is best suited for weekly charts. It is also referred to as a saucer bottom, and represents a long consolidation period that turns from a bearish bias to a bullish bias.

    1. There must be a Prior Trend to reverse. Ideally, the low of a rounding bottom will mark a new low or reaction low. In practice, there are occasions when the low is recorded many months earlier and the security trades flat before forming the pattern. When the rounding bottom does finally form, its low may not be the lowest low of the last few months.
    2. The first portion of the rounding bottom is the decline that leads to the low of the pattern. This decline can take on different forms: some are quite jagged with a number of reaction highs and lows, while others trade lower in a more linear fashion.
    3. The low of the rounding bottom can resemble a “V” bottom, but should not be too sharp and should take a few weeks to form. Because prices are in a long-term decline, the possibility of a selling climax exists that could create a lower spike.
    4. The advance off of the lows forms the right half of the pattern and should take about the same amount of time as the prior decline. If the advance is too sharp, then the validity of a rounding bottom may be in question.
    5. Breakout: Bullish confirmation comes when the pattern breaks above the reaction high that marked the beginning of the decline at the start of the pattern. As with most resistance breakouts, this level can become support. However, rounding bottoms represent long-term reversal and this new support level may not be that significant.
    6. In an ideal pattern, volume levels will track the shape of the rounding bottom: high at the beginning of the decline, low at the end of the decline and rising during the advance. Volume levels are not too important on the decline, but there should be an increase in volume on the advance and preferably on the breakout.

    A rounding bottom could be thought of as a head and shoulders bottom without readily identifiable shoulders. The head represents the low and is fairly central to the pattern. The volume patterns are similar and confirmation comes with a resistance breakout. While symmetry is preferable on the rounding bottom, the left and right side do not have to be equal in time or slope. The important thing is to capture the essence of the pattern.

  10. Rising Wedge (Bearish)

    The Rising Wedge is a bearish pattern that begins wide at the bottom and contracts as prices move higher and the trading range narrows. In contrast to symmetrical triangles, which have no definitive slope and no bullish or bearish bias, rising wedges definitely slope up and have a bearish bias.

    The pattern can also fit into the continuation category. As a continuation pattern, the rising wedge will still slope up, but the slope will be against the prevailing downtrend. As a reversal pattern, the rising wedge will slope up and with the prevailing trend. Regardless of the type (reversal or continuation), rising wedges are bearish.

    1. There must be a Prior Trend to reverse. The rising wedge usually forms over a 3-6 month period and can mark an intermediate or long-term trend reversal. Sometimes the current trend is totally contained within the rising wedge; other times the pattern will form after an extended advance.
    2. It takes at least two reaction highs to form the Upper Resistance Line, ideally three. Each reaction high should be higher than the previous high.
    3. At least two reaction lows are required to form the Lower Support Line. Each reaction low should be higher than the previous low.
    4. The upper resistance line and lower support line contract and converge as the pattern matures. The advances from the reaction lows (lower support line) become shorter and shorter, which makes the rallies unconvincing. This creates an upper resistance line that fails to keep pace with the slope of the lower support line and indicates a supply overhang as prices increase.
    5. Bearish confirmation of the pattern does not come until the support line is broken in a convincing fashion. It is sometimes prudent to wait for a break of the previous reaction low. Once support is broken, there can sometimes be a reaction rally to test the newfound resistance level.
    6. Ideally, volume will decline as prices rise and the wedge evolves. An expansion of volume on the support line break can be taken as bearish confirmation.

    The rising wedge can be one of the most difficult chart patterns to accurately recognize and trade. While it is a consolidation formation, the loss of upside momentum on each successive high gives the pattern its bearish bias. However, the series of higher highs and higher lows keeps the trend inherently bullish. The final break of support indicates that the forces of supply have finally won out and lower prices are likely. There are no measuring techniques to estimate the decline – other aspects of technical analysis should be employed to forecast price targets.

  11. Falling Wedge (Bullish)

    The Falling Wedge is a bullish pattern that begins wide at the top and contracts as prices move lower. This price action forms a cone that slopes down as the reaction highs and reaction lows converge. In contrast to symmetrical triangles, which have no definitive slope and no bias, falling wedges definitely slope down and have a bullish bias. However, this bullish bias cannot be realized until a resistance breakout.

    The falling wedge can also fit into the continuation category. As a continuation pattern, the falling wedge will still slope down, but the slope will be against the prevailing uptrend. As a reversal pattern, the falling wedge slopes down and with the prevailing trend. Regardless of the type (reversal or continuation), falling wedges are regarded as bullish patterns.

    1. There must be a Prior Trend to reverse. Ideally, the falling wedge will form after an extended downtrend and mark the final low. The pattern usually forms over a 3-6 month period and the preceding downtrend should be at least 3 months old.
    2. It takes at least two reaction highs to form the Upper Resistance line, ideally three. Each reaction high should be lower than the previous highs.
    3. At least two reaction lows are required to form the lower Support Line. Each reaction low should be lower than the previous lows.
    4. The upper resistance line and lower support line contract and converge to form a cone as the pattern matures. The reaction lows still penetrate the previous lows, but this penetration becomes shallower. Shallower lows indicate a decrease in selling pressure and create a lower support line with less negative slope than the upper resistance line.
    5. Bullish confirmation of the pattern does not come until the resistance line is broken in convincing fashion. It is sometimes prudent to wait for a break above the previous reaction high for further confirmation. Once resistance is broken, there can sometimes be a correction to test the newfound support level.
    6. While Volume is not particularly important on rising wedges, Volume is an essential ingredient to confirm a falling wedge breakout. Without an expansion of volume, the breakout will lack conviction and be vulnerable to failure.
    7. As with rising wedges, the falling wedge can be one of the most difficult chart patterns to accurately recognize and trade. When lower highs and lower lows form, as in a falling wedge, a security remains in a downtrend. The falling wedge is designed to spot a decrease in downside momentum and alert technicians to a potential trend reversal. Even though selling pressure may be diminishing, demand does not win out until resistance is broken.

These patterns usually a sideways price action or a pause in the prevailing trend, and that the next move will be in the same direction as the trend that preceded the formation.

Reversals usually take much longer to build and represent major trend changes. Continuation patterns, on the other hand, are usually shorter in duration and are more accurately classified as near term or intermediate patterns.

In chart pattern analysis, there are always exceptions. Triangles are usually continuation patterns, but sometimes act as reversal patterns. Although triangles are usually considered intermediate patterns, they may occasionally appear on long term charts and take on major trend significance. A variation of the triangle – the inverted variety, usually signals a market top. Conversely, the head and shoulders pattern, the best known of the major reversal patterns, will on occasion be seen as a consolidation pattern.

There are three types of triangles – Symmetrical / Coil (I), Ascending (II) and Descending (III). Other notable continuation patterns include the Broadening Top (IV), Broadening Bottom (V), and the Cup and Handle (VI). There are also short-term continuation patterns like the Flags and Pennants (VII). Like the major reversal patterns, each type has a slightly different shape and has different forecasting implications.

  1. Symmetrical or Coil

    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.

    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.

    1. 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.
    2. 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.
    3. 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.
    4. The symmetrical triangle can extend for a few weeks or many months. Typically, the time duration is about 3 months. If the pattern is less than 3 weeks, it is usually considered a pennant.
    5. 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.
    6. The future direction of the breakout can only be determined after the break has occurred. Sounds 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.
    7. 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.
    8. 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.
    9. There are two methods to estimate the extent of the move (Price Target) 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.
    10. Edwards and Magee suggest that roughly 75% of symmetrical triangles are continuation patterns and the rest mark reversals. The reversal patterns can be especially difficult to analyze and often have false breakouts. Even so, we should not anticipate the direction of the breakout, but rather wait for it to happen. Confirmation is especially important for upside breakouts.
    11. 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.
  2. Ascending or Right-Angle Triangle (Bullish)

    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.

    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.

    1. 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.
    2. At least 2 reaction highs 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.
    3. 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.
    4. The length of the pattern can range from a few weeks to many months with the average pattern lasting from 1-3 months.
    5. 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.
    6. Return to Breakout: 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.
    7. Once the breakout has occurred, the price projection (Price Target) is found by measuring the widest distance of the pattern and applying it to the resistance breakout.
    8. 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.
  3. Descending Triangle or Right Angle-Triangle (Bearish)

    The descending triangle is the bearish pattern counterpart of the Ascending Triangle. The pattern 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.

    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.

    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.

  4. Broadening Top (Bearish)

    1. Price trend: Upward leading to the pattern.
    2. A megaphone: Higher peaks and lower troughs. At least two peaks and two valleys should touch their respective trendlines. It is also known by the name Megaphone or Expanding Triangle.
    3. The top trendline slopes upward, the bottom one slopes downward.
    4. Volume is often often U-shaped.
    5. Breakout: Can occur in any direction (about 50%) and it happens when price pierces a trendline or moves beyond the end of the pattern.

    A pattern that occurs during high volatility, when a security shows great movement with little direction. As the two trendlines diverge from the apex, the pattern resembles a reverse version of a symmetrical triangle. This pattern is considered quite rare, but is useful in helping technicians to identify swing trades, rather than trend trades.

  5. Broadening Bottom (Bullish)

    1. Price trend: Downward 85% of the time leading to the pattern.
    2. Megaphone Shape: Higher peaks and lower trough. At least two peaks and two valleys should touch the associated trend line. It is also known by the name Megaphone or Expanding Triangle.
    3. The top trend line slopes upward, the bottom one slopes downward.
    4. Volume is often often U-shaped.
    5. Volume Upward 57% to 58% of the time.
    6. Breakout: Can occur in any direction (upward 53% of the time) and it happens when price pierces a trendline or moves beyond the end of the pattern.

    Notice that if you draw the top trendline to connect point B instead of C, the pattern would take on the appearance of a right-angled and descending broadening formation because the top trendline would be flat or nearly so. Also, price at E bounces to D and then makes a lower low at F. Point D looks like a partial rise which fails when the predicted breakout at F does not occur. This is one example of why trading broadening bottoms for profit is difficult, even if relying on a partial decline or partial rise.

  6. Cup and Handle (Bullish)

    The Cup with Handle is a bullish continuation pattern that marks a consolidation period followed by a breakout.

    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.

    1. 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.
    2. 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.
    3. 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 conforms with Dow Theory.
    4. 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 it is 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, 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.
    5. 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.
    6. There should be a substantial increase in Volume on the breakout above the handle’s resistance.
    7. The projected advance after breakout (Price Target) 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.

  7. Flags, Pennants

    Flags and Pennants are short-term continuation patterns that mark a small consolidation before the previous move resumes. These patterns are usually preceded by a sharp advance or decline with heavy volume, and mark a mid-point of the move.

    • To be considered a continuation pattern, there should be evidence of a prior trend. Flags and pennants require evidence of a sharp advance or decline on heavy volume. These moves usually occur on heavy volume and can contain gaps. This move usually represents the first leg of a significant advance or decline and the flag/pennant is merely a pause.
    • The Flagpole is the distance from the first resistance or support break to the high or low of the flag/pennant. The sharp advance (or decline) that forms the flagpole should break a trend line or resistance/support level. A line extending up from this break to the high of the flag/pennant forms the flagpole.
    • A Flag is a small rectangle pattern that slopes against the previous trend. If the previous move was up, then the flag would slope down. If the move was down, then the flag would slope up. Because flags are usually too short in duration to actually have reaction highs and lows, the price action just needs to be contained within two parallel trend lines.
    • A Pennant is a small symmetrical triangle that begins wide and converges as the pattern matures (like a cone). The slope is usually neutral. Sometimes there will not be specific reaction highs and lows from which to draw the trend lines and the price action should just be contained within the converging trend lines.
    • Flags and pennants are short-term patterns that can last from 1 to 12 weeks. There is some debate on the timeframe and some consider 8 weeks to be pushing the limits for a reliable pattern. Ideally, these patterns will form between 1 and 4 weeks. Once a flag becomes more than 12 weeks old, it would be classified as a rectangle. A pennant more than 12 weeks old would turn into a symmetrical triangle. The reliability of patterns that fall between 8 and 12 weeks is debatable.
    • Break: For a bullish flag or pennant, a break above resistance signals that the previous advance has resumed. For a bearish flag or pennant, a break below support signals that the previous decline has resumed.
    • Volume: Volume should be heavy during the advance or decline that forms the flagpole. Heavy volume provides legitimacy for the sudden and sharp move that creates the flagpole. An expansion of volume on the resistance (support) break lends credence to the validity of the formation and the likelihood of continuation.
    • The length of the flagpole can be applied to the resistance break or support break of the flag/pennant to estimate the advance or decline (Price Target).

    Even though flags and pennants are common formations, identification guidelines should not be taken lightly. It is important that flags and pennants are preceded by a sharp advance or decline. Without a sharp move, the reliability of the formation becomes questionable and trading could carry added risk. Look for volume confirmation on the initial move, consolidation and resumption to augment the robustness of pattern identification.

Moving Averages

The Moving Average is an average of certain body of data, smoothening data to show a trend more clearly.

Example

If a 10 day average of closing prices is desired, the prices for the last 10 days are added up and the total is divided by 10. The term moving is used because only the latest 10 days’ prices are used in the calculation. Each day the new close is added to the total and the close 11 days back is subtracted. The new total is then divided by the number of days (10).

As a trend following device, it tracks the progress of the trend. It is meant to identify or signal that a new trend has begun or that an old trend has ended or reversed. However, it does not predict market action in the same sense that standard chart analysis attempts to do. It never anticipates; it only reacts.

A shorter moving average, such as a 20 day average, would hug the price action more closely than a 200 day average. The time lag is reduced with shorter averages but can never be completely eliminated. Shorter term averages are more sensitive to price action, while longer term averages are less sensitive.

Simple / Exponential Moving Average

The Simple Moving Average (SMA) is used by most technical analysts. However, the tool only interprets the period covered by the average. The SMA gives equal weight to each day’s price but some chartists think that heavier weight should be given to the more recent price action.

Some traders just use one moving average wherein a buy signal is triggered when the closing price is above the moving average. Inversely, a sell signal is triggered when the closing price moves below the moving average.

While a sensitive signal has the advantage of giving trend signals earlier in the move, it also signals more possible trades (with higher commission costs) and can result in many false signals (whipsaws).

The longer average performs better while the trend remains in motion. However, the insensitivity of the longer average (because it is trailing the trend from a greater distance), works against the trader when the trend actually reverses.

The longer average works better as long as the trend remains in force, but a shorter average is better when the trend is in the process of reversing.

The Exponential Moving Average (EMA) assigns a greater weight to the more recent data; therefore, it is a weighted moving average. The tool is more flexible in that the user is able to adjust the weighting assigned to give greater or lesser weight to the most recent day’s price.

The Double Crossover Method uses two moving averages. A buy signal is produced when the shorter average crosses above the longer. The technique of using two averages together lags the market a bit more than the use of a single average but produces fewer whipsaws. Two popular combinations are the 5 and 20 day averages and the 10 and 50 day.

Stock Traders usually use a combination of any of the 10, 20, 50, 100 and 200 day moving averages.

Bollinger Bands

Two trading bands are placed around a moving average. Bollinger Bands are placed two standard deviations above and below the moving average, which is usually 20 days.

Standard deviation is a statistical concept that describes how prices are dispersed around an average value. Using two standard deviation ensures that 95% of the price data will fall between the two trading bands.

Prices on the upside are overbought when they touch the upper band and oversold on the downside when they touch the lower band. Upper and lower bands are used as price targets. If prices bounce off the lower band and cross above the 20 day average, the upper band becomes the price target and vice versa. In a strong uptrend, prices will usually fluctuate between the upper and 20 day average. In this case, the crossing below the 20 day average warns of a trend reversal to the downside.

Bollinger bands expand (in periods of volatility) and contract (in periods of low volatility) based on the last 20 days’ volatility. When the bands are usually far apart, that is often a sign that the trend may be ending. When the bands have narrowed too much, that is often a sign that a market may be about to initiate a new trend.

Oscillators

Oscillators are alternatives to the trend-following tools and are useful in nontrending markets where prices fluctuate in a trading range. It is also valuable used in conjunction with price charts in trending phases, alerting the trader to short term market extremes referred to as overbought or oversold conditions. The oscillator can also warn that a trend is losing momentum before the situation becomes evident in the price action itself. Oscillators can signal a trend may be nearing completion by displaying certain divergences.

Most oscillators look very much alike, plotted along the of the price chart and resemble a flat horizontal band. The oscillator band is basically flat while prices may be trading up, down or sideways. However, the peaks and troughs in the oscillator coincide with the peaks and troughs on the price chart. Some oscillators have a midpoint value that divides the horizontal range into two halves, an upper and a lower. Depending on the formula used, this midpoint line is usually a zero line. Some oscillators also have upper and lower boundaries ranging from 0 to 100.

As a general rule, when the oscillator reaches an extreme value in either the upper or lower end of the band, this suggests that the current price move may be due for a correction or consolidation. The trader should be buying when the oscillator line is in the lower end of the band (oversold) and selling in the upper end (overbought).

The oscillator is most useful in in three situations:

  1. An extreme reading in an oscillator is when it is near the upper (overbought) or lower part (oversold) of the band.
  2. A divergence between the oscillator and the price action when the oscillator is in an extreme position is usually an important warning.
  3. The crossing of the zero (or midpoint) line can give important trading signals in the direction of the price trend.

The Relative Strength Index (RSI)

While a 14 day period is the standard used, trader can change the period and adjust the sensitivity. The shorter the time period, the more sensitive the oscillator becomes and the wider its amplitude. RSI works best when its fluctuations reach the upper and lower extremes. Therefore, if the user is trading on a very short term basis and wants the oscillator swings to be more pronounced, the time period can be shortened. Inversely, the time period is lengthened to make the oscillator smoother and narrower in amplitude. The amplitude in the 9 day oscillator is greater than the 14 day. Some technicians use shorter lengths, such as 5 or 7 days, to increase the volatility of the RSI line. Others use 21 or 28 days to smooth out the RSI signals.

The RSI has a vertical scale of 0 to 100. Moves above 70 are considered overbought, while an oversold condition would be a move under 30. In bull and bear markets, these standards can change wherein the 80 level usually becomes the overbought level in bull markets and the 20 level becomes the oversold level in bear markets. Note that this standard changes when a shorter or longer time period. In a 3 day RSI, 90 can become the overbought level while 10 can be oversold.

The RSI has a vertical scale of 0 to 100. Moves above 70 are considered overbought, while an oversold condition would be a move under 30. In bull and bear markets, these standards can change wherein the 80 level usually becomes the overbought level in bull markets and the 20 level becomes the oversold level in bear markets. Note that this standard changes when a shorter or longer time period. In a 3 day RSI, 90 can become the overbought level while 10 can be oversold.

Divergence between the RSI and the price line, when the RSI is above 70 or below 30, is a serious signal to note.

Another consideration is that any strong trend, either up or down, usually produces an extreme oscillator reading. In these cases, claims that a market is overbought or oversold can be premature and can lead to an early exit from a profitable trend. The trader can shift time periods to suit his charting needs. The first move into the overbought or oversold region is usually just a warning. The signal to pay close attention to is the second move by the oscillator into danger zone. If the second move fails to confirm the price move into new highs or new lows (forming a double top or bottom on the oscillator), a possible divergence exists. This can be a cue to take defensive action by protect existing positions. If the oscillator moves in the opposite direction, breaking a previous high or low, then a divergence or failure swing is confirmed. The 50 level is the RSI midpoint value, and will often act as support during pullbacks and resistances during bounces. Some traders also treat RSI crossings above and below the 50 level as buying and selling signals respectively.

Stochastics

Based on the observation that as prices increase, closing prices tend to be closer to the upper end of the price range. In downtrends, the closing price tends to be near the lower end of the range. Two lines are used in the Stochastic process – the %K line and the %D line wherein %D is the more important line, providing the major signals. The tool helps determine where the most recent closing price is in relation to the price range for a chosen time period. The %D line (3-period moving average of the %K line) produces a version called fast stochastics and slow stochastics. Most traders use the slow stochastics because of its more reliable signals.

A very high reading (over 80) would put the closing price near the top of the range, while a low reading (under 20) near the bottom of the range.

Two lines will oscillate between 0 and 100. The K line is a faster line, while the D line is a slower line. The major signal to watch for is a divergence between the D line and the price of the underlying market when the D line is in an overbought or oversold area. The upper and lower extremes are the 80 and 20 values.

A bearish divergence occurs when the D line is over 80 and forms 2 declining peaks while prices continue to move higher. A bullish divergence is present when the D line is under 20 and forms 2 rising bottoms while prices continue to move lower. Assuming all of these factors have been set up, the actual buy or sell signal is triggered when the faster K line crosses the slower D line.

Moving Average Convergence/Divergence (MACD)

Combines some oscillator principles with a dual moving average crossover approach.

The faster line (MACD line) is the difference between 2 exponentially smoothed moving averages of closing prices (usually the last 12 and 26 says or weeks). The slower line (signal line) is usually a 9 period exponentially smoothed average of the MACD line.

The actual buy and sell signals are given when the two lines cross. A crossing by the faster MACD line above the slower signal line is a buy signal. A crossing by the faster MACD line below the signal line is a sell signal. The MACD resembles a dual moving average crossover method but also fluctuates above and below a zero line, resembling an oscillator.

An overbought condition is when lines are too far above the zero line. An oversold condition is when the lines are too far below the zero line. The best buy signals are given when the prices are well below the zero line (oversold). Crossings above and below the zero line are another way to generate buy and sell signals respectively.

Divergences appear between the trend of the MACD lines and the price line. A negative, or bearish, divergence exists when the MACD lines are well above the zero line (overbought) and start to weaken while prices continue to trend higher. Often a warning of a market top. A positive, or bullish divergence exists when the MACD lines are well below the zero line (oversold) and start to move up ahead of the price line. Often an early sign of a market bottom. Simple trendlines can be drawn on the MACD lines to help identify important trend changes.

Japanese Candlesticks present the same data as a line bar – open, high, low and close – but is more easily interpreted and analyzed.

White/Open Body

Close price higher than the open price.

Black/Filled Body

Close price lower than open price.

“Wicks”/Hairs/Shadows

High and Low prices

Different Body/Shadow combinations have different meanings, for example:

Long Days – Difference between open and close is great. Long white candlesticks show strong buying pressure while long black candlesticks show strong selling pressure. Short Days – Difference between open and close is short. Long upper shadow and short lower shadow indicate that buyers dominated during the session, and bid prices higher. However, sellers later forced prices down from their highs, and the weak close created a long upper shadow. Conversely, candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the session and drove prices lower. However, buyers later resurfaced to bid prices higher by the end of the session and the strong close created a long lower shadow.

Marubozu are more potent long candlesticks. They do not have upper or lower shadows and the high and low are represented by the open or close. A White Marubozu forms when the open equals the low and the close equals the high. This indicates that buyers controlled the price action from the first trade to the last trade. Black Marubozu form when the open equals the high and the close equals the low. This indicates that sellers controlled the price action from the first trade to the last trade.

Spinning Tops are small bodies with upper and lower shadows of greater length. Body color is less relevant as these are considered indecision days.

Doji. Open and Close prices are equal but can shadows of varying length.

Long-legged Doji. Long upper shadow and lower shadows. Indecision.

Gravestone Doji. Long upper shadow and no longer shadow. Bearish.

Dragonfly Doji. Opposite of a Gravestone Doji, long lower shadow and no upper shadow. Bullish.

Candlestick Patterns Analysis

Candlestick Patterns Analysis sees candle patterns as a depiction of traders’ mentality at the time. Can consist of a single candlestick or a combination (usually no more than 5). Patterns are used to determine reversals and trend continuation. A pair of patterns that work in both bullish and bearish situations usually have the same name; however, in some cases, counterparts have completely different names.

Reversal Candle Patterns

Reversal Candle Patterns must always be bucking the trend. There are 40 reversal candle patterns from single candlestick to more complex patterns of 5 candlesticks. Some of the more popular patterns are:

  • Dark Cloud Cover (Bearish) is 2-day reversal pattern. An uptrend is in place. The first day is a long white candlestick (confirming uptrend). The next day opens above the high price of the previous day, adding to the bullishness. However, trading for the rest of the day is lower with a close price at least below the mid-point of the body of the first day. Since the close price is below the open price, on the second day, the body is black. This is the dark cloud.
  • Piercing Line (Bullish) – Counterpart of the Dark Cloud Cover. A downtrend is in place. The first candlestick is a long black day. The next day, prices open at a new low and then trade higher all day and close above the midpoint of the first candlestick’s body.
  • Evening Star (Bearish) is a 3-day reversal pattern. The first day is a long white candlestick enforcing the uptrend. On the second day, prices gap up above the body of the first day but trading is somewhat restricted and close price is near the open price, while remaining above the body of the first day. This type of day following a long day is a Star pattern. A Star is a small body day that gaps away from a long body day. The third and last day opens with a gap below the body of the star and closes lower with the close price below the midpoint of the first day. The Morning Star is the bullish counterpart for this pattern.

Note: Some patterns may not meet each detail exactly. Details can be subjective when viewing a candlestick chart. 40 Major Candlestick Patterns

Continuation Patterns

Each trading day, a decision has to be made whether it is to exit a trade, enter a trade, or remain in a trade. The continuation pattern will help answer the question as to whether or not to remain in a trade. There are 16 continuation patterns. A bullish continuation pattern can only occur in an uptrend while a bearish continuation pattern can only occur in a downtrend.

  • Rising Three Methods (Bullish) – The first day is a long white day, supporting the uptrending market. However, over the course of the next 3 trading periods, small body days occur which, as a group, trend downward but remain within the range of the first day’s long white body and at least two of these three small-bodied days have black bodies; also known as a “period of rest.” On the fifth day, another long white day develops which closes at a new high. As prices break out of the short-term trading range, the uptrend will continue.

Note: Some patterns may not meet each detail exactly. Details can be subjective when viewing a candlestick chart. 40 Advanced Candlestick Patterns

Developed by R.N. Elliott and popularized by Robert Prechter in the 70s.

Suggests that crowd behavior ebbs and flows in clear trends. Identified a certain structure to price movements in the financial markets. The theory has a basic 5-wave impulse sequence and 3-wave corrective sequence. The theory gets more complicated than the 5-3 combination, but here only basic will be discussed.

2 Types of Waves: impulse and corrective. Impulse waves, also called motive waves, move in the direction of the larger degree wave, the bigger trend. While corrective waves move against the larger degree wave.

When the larger degree wave is up, advancing waves are impulsive and declining waves are corrective. When the larger degree wave is down, impulse waves are down and corrective waves are up.

Complete 8 Wave Cycle

A basic impulse wave forms a 5-wave sequence, labeled above as Bigger Wave I (1-2-3-4-5). Waves 1, 3 and 5 are impulse waves because they move with the trend. Waves 2 and 4 are corrective waves because they move against this bigger trend.

A basic corrective wave forms with three waves, typically a, b and c, labeled above as Bigger Wave II (a-b-c). In this wave, a and c are impulse waves (green). This is because they are in the direction of the larger degree wave. This entire move is clearly down, which represents the larger degree wave. Wave b, on the other hand, moves against the larger degree wave and is a corrective wave (red).

Fractal means that wave structure for the GrandSuper Cycle is the same as for the minuette. No matter how big or small the wave degree, impulse waves take on a 5-wave sequence and corrective waves take on a 3-wave sequence. Any impulse wave subdivides into 5 smaller waves. Any corrective wave subdivides into three smaller waves. The charts below show the fractal nature of Elliott Wave in action.

Note: The Elliott Wave Theory assigns a series of categories to the waves from largest to smallest. They are: Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor, Minute, Minuette, Sub-Minuette.

Three Rules

Rule 1:Wave 2 cannot retrace more than 100% of Wave 1. A break below this low would call for a re-count.

Rule 2: Wave 3 can never be the shortest of the three impulse waves. 1 or 5 can be longer than Wave 3, but both cannot be longer than Wave 3. Wave 3 must exceed the high of Wave 1. Failure to exceed this high would call for a re-count. Impulse moves are all about making progress.

Rule 3: Wave 4 can never overlap Wave 1. The low of Wave 4 cannot exceed the high of Wave 1. A break would call for a re-count.

Three Guidelines

Guideline 1: When Wave 3 is the longest impulse wave, Wave 5 will approximately equal Wave 1. The first guideline is useful for targeting the end of Wave 5, or at least initial projections.

Guideline 2: The forms for Wave 2 and Wave 4 will alternate. If Wave 2 is a sharp correction, Wave 4 will be a flat correction. If Wave 2 is flat, Wave 4 will be sharp. Useful for determining the time of correction for Wave 4. In practice, Wave 2 tends to be a rather sharp wave that retraces a large portion of Wave 1. Wave 4 comes after an extended Wave 3. This Wave 4 marks more of a consolidation that lays the groundwork for a Wave 5 trend resumption.

Guideline 3: After a 5-wave impulse advance, corrections (abc) usually end in the area of prior Wave 4 low. Waves 1-2-3-4-5 are lesser degree waves within Wave I. Once the Wave II correction unfolds, chartists can estimate its end by looking at the end of the prior wave 4 (lesser degree wave 4). Waves I and II are part of a larger degree uptrend.

Elliott Wave Theory application is highly subjective. In the case of using less emphasis on the correct wave count, a trader can still be profitable by determining the primary direction of the trend, properly differentiate between the primary and corrective waves, and use tight stops and realistic profit targets.

In the 1970s, Frost and Prechter published a book entitled “The Elliott Wave Principle – The Key to Stock Market Profits”. In this book, the authors predicted the bull market of the 1970s, and Robert Prechter called the crash of 1987. However, Prechter’s record at the end of the twentieth century has not been stellar. In his book, “At The Crest Of The Tidal Wave” (1995), he publicly called for the end of the great bull market in 1995, was nearly five years and many Dow points premature; he was advising clients to exit the market even though the ascent was nowhere near its end.

  1. Direction of overall Market, Sector, Stock. Up, Down or Sideways?
  2. Multi-year, Monthly, Weekly, Daily and Intradaily charts
  3. Major, Intermediate and Minor Trends. Up, Down or Sideways?
  4. Supports and Resistances. (Use 33-38%, 50% and 62-68% as guide)
  5. Trendlines and/or Channels
  6. Volume (Note: More important in downtrends)
  7. Price Gaps
  8. Major Reversal or Continuation Patterns
  9. Price Objectives (Note: Applies to both Upside/Downside)
  10. Moving Average trend
  11. Oscillators (Overbought or Oversold), Divergences
  12. Elliot Wave Pattern
  13. Candlesticks
  1. Investment Time Frame. Market trend (major, intermediate or minor) within that time frame.
  2. Buy, Sell or Trade the Range (Buy and Sell within an established trading range, ensure protective stop when market decides on a direction).
  3. Investment units (Trading and/or Core)
  4. Risk-Reward Ratio. Loss threshold. Protective Stop.
  5. Profit Objective

Increasing the odds of winning in the market involves Knowledge (Know the rules), Discipline (Apply the rules) and Patience (Invest/Trade at a low-risk, high-reward opportunity).


Money Management

Money Management refers to allocation of funds. This includes Portfolio Make-up, Diversification, the Use of Stops, Risk-Reward Ratios, what to do after Periods of Success and Adversity and whether to Trade Conservatively or Aggressively.

Topics:

In determining Portfolio Make-up, you must remember that total invested funds in any investment instrument must represent only a % of total investible capital. An investor may want to make a distinction between risk-free to riskier assets ranging from a focus on capital preservation to growth as goals for each fund. Some options are SDA, regular savings account or time deposit, government bonds, commercial bonds, UITFs, mutual funds or equities (also called stocks).

Diversify but don’t over-diversify as a few profitable trades may be diluted by a larger number of losing trades. Stocks tend to move with the sector they belong to, so diversifying investments by sector is one option. Some sectors can also move in tandem such as in the case of rate-sensitive Bank and Property sectors.

Protective Stops. Stop Placement is an art. The more volatile the market, the looser the stop should be. A trader would want the protective stop to be close enough so that losing trades are as small as possible. However, stops that are too close may result to an unwanted liquidation on short-term market swings or “noise.” It is also important to consider your loss threshold.

Risk-Reward Ratio. In every potential trade, there is a potential loss (the risk) or a profit objective (the reward). A commonly used standard is the 1:3 ratio wherein the profit potential is 3x the loss potential. A commonly applied theory is to “Let profits run and cut losses short” as large profits in trading are achieved with persistent trends.

Trading in Multiple Units. These units can be divided into trading and trending (also called a core position). While the trending (core) position is for the long pull with loose protective stops allowing for market to consolidate or correct. On the other hand, the trading position is earmarked for shorter-term in-and-out trading; using resistances/overbought as indicators, some profit can be taken or a protective stop utilized.

Periods of Success and Adversity. Every trader’s track record is a series of peaks and troughs, much like a price chart. The worst time to increase the size of one’s commitments is after a winning streak. Overconfidence can sometimes get the better of an investor who may be willing to add to a current winning position that may already be too late into the game. The wiser thing to do is to increase one’s commitments after a dip in equity (which goes against basic human nature).

If you’ve gone through our basic references in trading the stock market, you should be able to make key Investing decisions by knowing What to do (Fundamental Analysis), When to do it (Technical Analysis), and How much to commit (Money Management).

  1. Trade in the direction of the intermediate trend.
  2. In uptrends, buy the dip. In downtrends, sell the rallies.
  3. Let profits run, cut losses short.
  4. Use protective stops to limit losses.
  5. Have a plan. Trade according to plan and not emotion.
  6. Don’t trade with the herd. Look well into your own investments and time your trades.
  7. Money manage
  8. Diversify but don’t over-diversify
  9. Trade on a Risk-Reward Ratio of 1:3
  10. In pyramiding, each successive layer should be smaller than before. Add only to winning positions, not losing ones.
  11. Except for very short term trading, make decisions away from the market, even better when it is closed.
  12. Work from long term to short term.
  13. Shorter term charts are used to fine-tune entry and exit
  14. Master interday trading before trying intraday trading
  15. Keep it simple. More complicated isn’t always better. You can create your own method that best applies to your investment goals.
  16. Remember though that the market is a dynamic landscape. Keep learning more about investment practices as much as the companies you’re investing in.

Behind every stock is a company. Find out what it’s doing. Peter Lynch

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