Widely known for their ability to incorporate volatility and capture price action, Bollinger bands have been a favorite staple of traders in the FX market. However, there are other technical options that traders in the currency markets can apply to capture profitable opportunities in swing action. Lesser-known band indicators such as Donchian channels, Keltner channels and STARC bands are all used to isolate such opportunities. Also used in the futures and options markets, these technical indicators have a lot to offer given the vast liquidity and technical nature of the FX forum. Differing in underlying calculations and interpretations, each study is unique because it highlights different components of the price action. Here we explain how Donchian channels, Keltner channels and STARC bands work and how you can use them to your advantage in the FX market.
Donchian Channels
Donchian channels are price channel studies that are available on most charting packages and can be profitably applied by both novice and expert traders. Although the application was intended mostly for the commodity futures market, these channels can also be widely used in the FX market to capture short-term bursts or longer-term trends. Created by Richard Donchian, considered to be the father of successful trend following, the study contains the underlying currency fluctuations and aims to place profitable entries upon the start of a new trend through penetration of either the lower or upper band. Based on a 20-period moving average (and thus sometimes referred to as a moving average indicator), the application additionally establishes bands that plot the highest high and lowest low. As a result, the following signals are produced:
A buy, or long, signal is created when the price action breaks through and closes above the upper band.
A sell, or short, signal is created when the price action breaks though and closes below the lower band.
The theory behind the signals may seem a little confusing at first, as most traders assume that a break of the upper or lower boundary signals a reversal, but it is actually quite simple. If the current price action is able to surpass the range's high (provided enough momentum exists), then a new high will be established because an uptrend is ensuing. Conversely, if the price action can crash through the range's low, a new downtrend may be in the works. Let's look at a prime example of how this theory works in the FX markets.
Figure 1 - A typical example of the effectiveness of Donchian channels
Channel trading is a powerful yet often overlooked form of trading that capitalizes on the tendencies of markets to trend. It combines several forms of technical analysis to provide traders with precise points from which to buy and sell, put stop-loss and take-profit levels, and much more! This article will show you how to create and effectively trade these amazing instruments.
Channel Characteristics
In the context of technical analysis, a channel is defined as the area between two parallel trendlines and is often taken as a measure of a trading range. The upper trendline connects price peaks (highs) or closes, and the lower trendline connects lows or closes. An example of a channel is shown below.Breakout points in channels indicate bullish (on upward trends) or bearish (on downward trends) signals.
Channels are useful for short-to medium-term trading - not long-term trading or investing. The technique often works best on stocks with a medium amount of volatility. Remember, the volatility determines your profit per trade. Channeling also tend to work best when the technique is combined with other forms of technical analysis, at which we take a closer look below.
Finding an Equity
Not all equities can utilize this technique as it requires that the underlying equity has an existing channel in its chart. Generally, a channel consisting of four contact points is necessary for the channel to be considered “trade-able”. There are three ways to locate an equity to which this strategy can be applied:
1. Manually look through charts to locate channel patterns.
2. Utilize software or a service that automatically recognizes channel patterns.
3. Subscribe to a company that provides you with a list of equities to which this technique can be applied.
Creating a Channel
Channels are relatively easy to create using these four simple steps:
1. Locate a relative high and a relative low in the past from which to begin the channel.
2. Locate another subsequent high and low that follows one of the three following patterns (see table below):
a. Ascending channel - higher high and higher low.
b. Descending channel- lower low and lower high.
c. Horizontal channel- horizontal highs and lows.
3. Draw two trend lines - one connecting the two highs, and one connecting the two lows. Note that these two lines should be near parallel.
4. These two lines form your basic channel after there are at least two contact points with the upper channel and two with the lower channel. More contact points enhance the reliability of the channel.
Trading the Channel
Channels provide a clear, systematic way to trade. In fact, these simple instruments can show you when to buy and sell, where to place your stop-loss and take-profit points, how to determine the reliability of the trade and how long you should expect the trade to take! Let's look at how these can be done...
Locating Buy and Sell Points
Channels help locate optimal buying and selling points. Here are the standard channel trading rules:
• When the price hits the top of the channel, sell your existing position and/or take a short position.
• When the price is in the middle of the channel, hold.
• When the price hits the bottom of the channel, add to your existing position, cover your short and/or buy.
Two exceptions to these rules:
1. If the price breaks through the top or bottom of the channel, then the channel play ends until a new channel is established.
2. If the price drifts between the channels for a prolonged period of time, a new narrower channel may be established.
There may be times when other forms of technical analysis are needed to enhance the accuracy of the channel plays, and verify the overall strength of the channel. Using other techniques in conjunction with channeling can also help you avoid the side-effects of the two exceptions listed above. A few useful ones to keep in mind are:
• Moving average convergence divergence - These can be used to confirm channel movements, especially after a contact is made.
• Stochastics - These are useful to confirm channel movements.
• Volume - Analyzing volume ratios can also help you determine the strengths of different channel movements, which determine the overall channel strength.
• Short-term moving averages - These can provide you with a short-term outlook on a channel play. They are most useful after a contact is made to confirm the change in direction.
• Candlestick patterns - These are useful for spotting channel breakouts.
Determining Stop-Loss and Take-Profit Levels
Channels provide built-in money-management capabilities in the form of stop-loss and take-profit points. Here are the standard rules for determining these points:
• If you have bought at the bottom of the channel, set a (moving) take-profit point at the top of the channel. Also, set a (moving) stop-loss point slightly below the bottom of the channel, allowing room for regular volatility (taking the beta into consideration).
• If you have taken a short position at the top of the channel, set a (moving) take-profit point at the bottom of the channel. Also, set a (moving) stop-loss slightly above the top of the channel, allowing room for regular volatility (taking the beta into consideration).
Determining Trade Reliability
Channels provide the ability to determine how likely your trade is to be successful. This is done through something known as confirmations. Confirmations represent the number of times the price has rebounded from the top or bottom of the channel - in essence confirming the accuracy of the channel. Here are the important confirmation levels to remember:
• 1-2 - Weak channel (non-trade-able).
• 3-4 - Adequate channel (trade-able).
• 5-6 - Strong channel (reliable).
• 6+ - Very strong channel (very reliable).
Estimating Trade Length
The amount of time a trade takes to reach a sell point from a buy point can also be calculated using channels. This is done by recording the amount of time it has taken for trades to execute in the past, then averaging the amount of time for the future. This strategy relies on the theory that channel price movements tend to be nearly equal in time and price.
Conclusion
Channels provide one of the most accurate methods from which to trade in any market. By “encasing” an equities price movement into two parallel trend lines, this simple chart can provide the exact points from which to buy and sell, create stop-loss and take-profit points, check channel strength and even estimate how long the trade will take. This technique is a valuable asset to any trader.
Resources
Voodoo Trader (http://www.chart.nu) - A free service that automatically locates stocks that are compatible with channel trading.
ChartAdvisor (http://www.chartadvisor.com) - A paid service that identifies chart patterns.
Tradecision (http://www.tradecision.com) - Trading software that automatically generates various technical formations, including channels.
by Justin Kuepper
Justin Kuepper has many years of experience in the market as an active trader and a personal retirement accounts manager. He spent a few years independently building and managing financial portals before obtaining his current position with Accelerized New Media, owner of SECFilings.com, ExecutiveDisclosure.com and other popular financial portals. Kuepper continues to write on a freelance basis, covering both finance and technology topics.
Creating a support/resistance tunnel on the price congestion and trading on the break of this tunnel is a milestone of Forex trading discoveries.
This trading system/approach needs no indicators and can be applied to any currency and traded in any time frame where coiling in a tight range is spotted.
Entry rules: Find consolidation on the chart and draw two horizontal trend lines – support and resistance. Once the price breaks trough one of the trend lines and a current price bar closes outside the tunnel – buy/sell in the direction of the breakout. (If price pierces the trend line, but did not close outside the tunnel, cancel the previous trend line and draw another one according to the new conditions).
Note: also very often happens that once the price makes it through support or resistance it rocks down/up very quickly and so, more aggressive entry can also be adopted – without waiting for the current price bar to close.
Exit rules: not set, however, it is believed, that the price after breaking the tunnel will travel the distance equal to the width of that tunnel. Advantages: very simple and extremely effective. It can provide 100% profitable entries if short profits are taken - usually with the close of the first candle right after the entry. Disadvantages: very accurate and well thought entry point should be picked. Orders placed very close to the tunnel can be triggered by sudden whipsaw early before real breakthrough occur. http://forex-strategies-revealed.com/
There are different reversal patterns that can be used in forex technical analysis. This article considers two of them - the Head-And-Shoulders and the Inverted Head-And-Shoulders.
Head-And-Shoulders Trend Reversal Pattern
The head-and-shoulders pattern is one of the most reliable and popular trend reversal patterns that can be observed on charts. This chart formation includes three successive rallies and depicts the following currency price movement:
The currency price rises to a peak and then declines.
The price rises again, this time above the previous peak, and then declines again.
The price rises for a third time, this time below the second peak, and then declines again.
The shoulders are represented by the first and the third peaks, which are of an about equal height. The head is represented by the middle peak, which is the highest of the three. The neckline is the support line on which all of the three rallies are based. The head-and-shoulders pattern is considered confirmed and complete when the price falls below the neckline after the second shoulder.
In order that the head-and-shoulders formation successfully develops, the neckline should be broken under the conditions of a heavy market volume. As a sign for a false breakout a breakout occurring on a light volume is considered. This will cause an adverse reaction in the price of the currency.
What does a classic head and shoulders top look like?
As depicted below, the classic head and shoulders top looks like a human head with shoulders on either side of the head. A perfect example of the pattern has three sharp high points, created by three successive rallies in the price of the stock.
The first point - the left shoulder - occurs as the price of the stock in a rising market hits a high and then falls back. The second point - the head - happens when prices rise to an even higher high and then fall back again. The third point - the right shoulder - occurs when prices rise again but don't hit the high of the head. Prices then fall back again once they have hit the high of the right shoulder. The shoulders are definitely lower than the head and, in a classic formation, are often roughly equal to one another.
A key element of the pattern is the neckline. The neckline is formed by drawing a line connecting two low price points of the formation. The first low point occurs at the end of the left shoulder and the beginning of the uptrend to the head. The second marks the end of the head and the beginning of the upturn to the right shoulder. The neckline can be horizontal or it can slope up or down. However, as Elaine Yager, Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors points out, a Head and Shoulders Top neckline that is sloping downwards is highly unusual and demonstrates extreme weakness.
The pattern is complete when the support provided by the neckline is "broken." This occurs when the price of the stock, falling from the high point of the right shoulder, moves below the neckline. Technical analysts will often say that the pattern is not confirmed until the price closes below the neckline - it is not enough for it to trade below the neckline.
A classic head and shoulders top has been described above. There are many variations, some of which are described here and can be just as valid as the classic formation. Other factors - including volume and the quality of the breakout - should be considered in conjunction with the pattern itself.
Is volume important in a head and shoulders top?
Volume is extremely important for this pattern.
For a head and shoulders top the volume pattern is as follows.
Volume is highest when the left shoulder is forming. In fact, volume is often expanding as the uptrend continues and more and more buyers want to get in.
Volume is lowest on the right shoulder as investors see a reversal happening. Experts say low volume levels on the right shoulder are a strong sign of a reversal.
In the head portion of the price pattern, volume falls somewhere between the strength of the left shoulder and weakness of the right shoulder. Volume often increases when the neckline is broken as the reversal is now complete and downside pressure begins in earnest. In fact, Yager notes that one of the key characteristics she looks for in a Head and Shoulders Top is very high volume on the breakout.
Although volume is important, experts warn us not to get caught up in the precise number of shares being traded.What we're looking for are changes in the rate of trading.
What are the details that I should pay attention to in the head and shoulders top?
There are certain characteristics that experts like to see in the pattern.
1. Symmetry - The right and left shoulders should peak at approximately the same price level. In addition, the shoulders are often about the same distance from the head. In other words, there should be about the same amount of time between the development of the top of the left shoulder and the head as between the head and the top of the right shoulder. In the real world, the formation will seldom be perfectly symmetrical. Sometimes one shoulder will be higher than the other or take more time to develop. Experts warn, however, that if a shoulder reaches the level of the head, you're no longer looking at a head and shoulders top.
2. Volume - The importance of volume has already been discussed. In summary, volume should be highest on the left shoulder, lowest on the right shoulder and somewhere in between on the head. The real tip-off in this formation occurs when activity fails to rally on the right shoulder.
3. Duration of the Pattern - Some experts say that an average pattern takes at least three months from start to the breakout point when the neckline is broken. It is not uncommon, however, for a pattern to last up to six months. The duration of the pattern is sometimes called the "width" of the pattern.
4. Need for an Uptrend - This is a reversal pattern which marks the transition from an uptrend in prices to a downtrend. This means that the formation always begins during an uptrend of stock prices. Yager goes further to say that she only considers a Head and Shoulders Top pattern significant if the trend has been in existence for more than a year.
5. Slope of the Neckline - The neckline can slope up or down. The direction of the slope tends to predict the severity of the price decline. An upward sloping neckline is considered to be more bullish than a downward sloping one, which indicates a weaker situation with more drastic price declines. However, as noted above it is rather rare to have a downward sloping neckline for this pattern.
6. Decisive Neckline Break - To be complete, the neckline must be decisively broken. If the support at the neckline holds - if price bounces around the neckline or fails to move below the neckline - this is a sign that the reversal pattern has failed. If the pattern fails to decisively break through the neckline, prices will often move higher as the rally continues. Experts advise "beware a complicated right shoulder," where prices bounce around without decisively breaking through the neckline.
How can I trade this pattern?
Begin by computing the target price. The measuring technique is as follows. Begin by computing the height of the pattern. To do this, measure the number of points vertically down from the top of the head to the neckline. Subtract this number from the point where the price finally breaks the neckline, marking the end of the right shoulder. The difference is the minimum target price.
For example, assume the top of the head is 140 and the neckline vertically under it is 110. The height of the pattern is 30 (140 - 110 = 30). Assume the neckline was broken at 80. That means the downside objective is projected at 50 (80 - 30 = 50). This target price of 50 is only a guide, affected by a variety of the other factors already mentioned. Experts remind us that this target is a minimum target.Prices will often move beyond that objective.
The way you trade this pattern will depend on how aggressive you are. No matter what your personality type, however, your trading focus will be on "breaking the neck." The pattern is not complete until the neckline is conclusively broken by the right shoulder.
On the aggressive end, Bulkowski suggests that, if you are confident that a head and shoulders formation is shaping up validly, that you should sell your stock or sell short once the right shoulder forms. He believes that because his statistics show that the pattern has a 93% success rate, there's no need to wait for a confirmed breakout before entering the trading arena.
Others are less aggressive. Murphy, for example, places strong emphasis on ensuring that the pattern is complete. This can be seen by a significant breaking of the neckline, which he refers to as a "decisive closing violation" of the neckline.He argues that until that violation takes place, it's always possible that the pattern is not a head and shoulders top and that the downtrend may never take place.
Murphy advises keeping a close eye on the "return move." Sometimes, after the neckline is broken on the right shoulder, the pattern bounces back up to the neckline. This is called a return move. The return move, if it occurs at all, is often only a minor and short-lived bounce. If the neckline is broken on heavy volume, this diminishes the possibility that there will even by a return move. However, don't discount the bounce. If the price keeps hovering around the neckline without a decisive break, it may not be a head and shoulders reversal and the uptrend may resume.
Edwards and Magee call a close below the neckline break of approximately 3% of the price of the stock the "breakout" or "confirmation" of the head and shoulders top.The authors warn that up to 20% of head and shoulders tops are "saved," where prices keep bouncing around the low point of the right shoulder, before they eventually head back up.
According to Murphy, there are two tests that can be applied to determine whether the pattern is complete. He applies the 1 to 3% penetration criterion (see Edwards and Magee above) and confirms the neckline break with the "two-day rule," the requirement of the two successive closes below the neckline.
Are there variations in the pattern that I should know about?
There are a few notable variations.
Watch for the Drooping Shoulder
According to Schabacker, the drooping shoulder - where neckline has a downward slope - can often indicate a rapidly developing technical weakness. The droop happens because the stock price at the end of the head and the beginning of the right shoulder have dropped even lower than the previous low at the end of the left shoulder and the beginning of the head. Most experts agree that a downward slope has bearish implications for market weakness. Typically when the right shoulder is drooping, the trader will have to wait longer than usual for a decisive neck break. Murphy points out that when that decisive break does occur much of the move will have already occurred.
Varying Width of Shoulders
The classic head and shoulders top is symmetrical. However, if the shoulders don't match in width, don't discount the pattern. According to Schabacker, it's common for one shoulder to take longer to form than the other.If the pattern decisively breaks the neckline, it's still a valid head and shoulders top.
Flat Shoulders
While the classic head and shoulders top is made up of three sharp upward points, these need not be present for the pattern to be valid. Sometimes, shoulders can be rounded.
Multiple Head and Shoulders Patterns
Many valid head and shoulders patterns are not as well defined as the classical head with a shoulder on either side. "Complex" formations can have more variations than the classical formation. It is not uncommon to see more than two shoulders and more than one head. Edwards and Magee advise that any combination is possible, but a multiple head and shoulders is seen more often in a head and shoulders bottom rather than a top. A common version of a multiple head and shoulders pattern includes two left shoulders of more or less equal size, one head, and then two right shoulders that mimic the size and shape of the left shoulders.
A mirror image of the head-and-shoulders formation is the inverted head-and-shoulders pattern. This means that the same characteristics as well as potential drawbacks and signals can be referred to this type of chart formation.
The pattern includes three successive lows and depicts the following currency price movement:
The currency price falls to a low and then rallies.
The price falls again, this time below the previous low, and then rallies again.
The price falls for a third time, this time above the second low, and then it rallies again.
The inverted head-and-shoulders reversal pattern is considered complete when the price rises above the neckline.
What does a classic head and shoulders bottom look like?
As shown below, the head and shoulders bottom, also referred to as an inverse head and shoulders, looks like a top, except reversed. A perfect example of the head and shoulders bottom has three sharp low points created by three successive reactions in the price of the stock. It is essential that this pattern form following a prior major downtrend in a stock's price.
The first point,- the left shoulder, -occurs as the price of the stock in a falling market hits a new low and then rises in a minor recovery. The second point, -the head, happens when prices fall from the high of the left shoulder to an even lower level and then rise again. The third point, -the right shoulder, -occurs when prices fall again but don't hit the low of the head. Prices then rise again once they have hit the low of the right shoulder. The lows of the shoulders are definitely higher than that of the head and, in a classic formation, are often roughly equal to one another.
The neckline is a key element of this pattern. The neckline is formed by drawing a line connecting two high price points of the formation. The first high point occurs at the end of the left shoulder and beginning of the downtrend to the head. The second marks the end of the head and the beginning of the downturn to the right shoulder. The neckline usually points down in a head and shoulders bottom, but on rare occasions can slope up.
The pattern is complete when the resistance marked by the neckline is "broken." This occurs when the price of the stock, rising from the low point of the right shoulder moves up through the neckline. Many technical analysts only consider the neckline "broken" if the stock closes above the neckline.
Is volume important in a head and shoulders bottom?
It is crucial for an investor to monitor the volume pattern to determine if what looks like a forming head and shoulders bottom will prove dependable.
The volume sequence should progress in a fairly predictable way, beginning with relatively heavy volume as prices descend to form the low point of the left shoulder. Once again, volume spikes as the stock hits a new low to form the point of the head. It is possible that volume at the head may be slightly lower than at the left shoulder. When the right shoulder is forming, however, volume should be markedly lighter as the price of the stock once again moves lower.
It is most important to watch volume at the point where the neckline is broken. For a true reversal, experts agree that heavy volume is essential. Murphy advises looking for a "sharp burst" of trading volume. This increase in volume marks an increase in demand at higher prices. Buyers have entered the market in greater numbers.
What are the details that I should pay attention to in the head and shoulders bottom?
There are certain characteristics that experts like to see in the pattern.
1. Symmetry - In a classic head and shoulders bottom, the left and right shoulders hit their relative low points at approximately the same price and level. In addition, the shoulders are usually about the same distance from the head. Experts like to see symmetry but variations are not lethal to the validity of the pattern. Bulkowski comments that wide variations between the shoulders (they can vary in height or width) are common in the pattern. The head, however, is noticeably symmetrical. If a shoulder hits the low point marked by the top of the head, the pattern is not a head and shoulders bottom.
2. Volume - As mentioned earlier, it is critical to watch the volume sequence as this pattern develops.
Volume will usually be highest on the left shoulder and lowest on the right.
Investors, looking to ensure that volume increases in the direction of the trend, should ensure that a "burst" in volume occurs at the time the neckline is broken.
Experts, including Murphy, maintain that the volume pick-up at the end of the pattern is essential. "If the volume pattern does not show a significant increase during the upside price breakout, the entire pattern should be questioned." Other experts, including Bulkowski, are not so convinced: "a low volume breakout is not an indicator of an impending failure."
3. Duration of Pattern - A bottoming pattern is usually longer in duration and less volatile than a top. In addition, price swings are more marked in tops than in bottoms. According to Edwards and Magee, bottoms tend to be longer and flatter than tops. It is not unusual for a head and shoulders bottom to take several months to develop. Schabacker explains that volume activity in stocks is characteristically less after a period of declining prices than after a bull market. Because of this lower volume, patterns take longer to form and tend to be smaller than tops.
4. Need for a Downtrend - This is a reversal pattern which marks the transition from a downtrend to an uptrend. According to Yager, the formation always begins during a major downtrend in the stock's price.
5. Slope of the Neckline - In a well-formed pattern, the slope will not be too steep, but don't automatically discount a formation with a steep neckline.Some experts believe an upward sloping neckline is more bullish than a downward sloping one. Others say slope has little to do with the stock's degree of bullishness.The slope of a neckline can be too steep however. Bulkowski recommends that if a neckline is too steep, an investor should consider the highest rise between the shoulders as the breakout level, rather than the piercing of the neckline.
6. Decisive Neckline Break - As mentioned earlier, the pattern is not complete until the neckline is broken and the breakout or confirmation must occur with a convincing burst of trading activity.
How can I trade this pattern?
Begin by computing the target price. Compute the height of the pattern by measuring the number of points vertically up from the bottom of the head to the neckline. Add this number to the point where prices finally break the neckline, marking the end of the right shoulder. The sum is the minimum price target.
For example, assume the bottom of the head is 110 and the neckline vertically above it is 140. The height of the pattern is 30 (140 - 110 = 30). Assume the neckline was broken at 130. That means the upside objective is projected at 160 (130 + 30 = 160). This target price of 160 is only a guide and can be affected by a variety of other factors already mentioned. Because this projected price is a minimum target, prices will often move beyond that objective.
Yager uses two measurements, one to confirm the formation of the pattern and one to compute a target price. As in the calculation above, compute the height of the pattern by measuring the number of points vertically up from the bottom of the head to the neckline. Take the height and add it to the price which marks the bottom of the right shoulder. This calculation should be done only when the price has penetrated the neckline. The pattern is confirmed when this price target is reached.
Then take the height and add it to the neckline marking the end of the right shoulder. This second measurement is the price objective.
For example, assume the bottom of the head is 110 and the neckline vertically above it is 140. The height of the pattern is 30 (140 - 110 = 30). Assume the bottom of the right shoulder is 120 and the neckline was broken at 130. The confirmation point is therefore 150 (120 + 30 = 150) and the upside objective is projected at 160 (130 + 30 = 160). Bulkowski suggests modifying this calculation method in situations where the neckline is particularly steep and up-sloping. "Substitute the rise between the head and right shoulder (that is the highest price in the rise) for the neckline breakout price."
Bulkowski's advice is in keeping with his aggressive approach to trading a head and shoulders bottom.
According to Bulkowski, "if you can determine that a head and shoulders formation is completing, consider buying the stock. The formation rarely disappoints and the rise is worth betting on."He does continue, however, to caution potential investors to first be sure that what they are looking at is a true head and shoulders bottom. If you're unsure, he advises, wait for the breakout at the neckline.
Schabacker advises patience when monitoring the development of this pattern. He bases this on the fact that a head and shoulders bottom tends to take longer to form and is smaller in size to a head and shoulders top. Don't expect the time frames for pattern development to mimic that of the head and shoulders top. Murphy suggests the investor use this difference to his or her advantage. Because of the smaller price ranges and slower development time, "it is usually easier and less costly to identify and trade bottoms than to catch market tops." Although, he concludes, because prices tend to decline faster than they go up, an investor can reap greater rewards trading a head and shoulders top. This greater reward is accompanied by greater risk.
Murphy is adamant that increasing volume is a critical confirming pattern in the completion of a head and shoulders bottom. "If the volume pattern does not show a significant increase during the upside price breakout, the entire pattern should be questioned."
Bulkowski advises investors that if they miss the upside breakout, they should wait and watch. They may not have lost a trading opportunity. "Half the time, the stock will throw back to the neckline. Once it does, buy the stock or add to your position."
Edwards and Magee call a close above the neckline break of approximately 3% of the stock's market price the "breakout" or "confirmation" of the head and shoulders bottom.
Are there variations in the pattern I should know about?
There are a few notable variations:
Multiple Head and Shoulders Patterns
Many valid head and shoulders patterns are not as well defined as the classical head with a shoulder on either side. "Complex" formations can have more variations than the classical formation. It is not uncommon to see more than two shoulders and more than one head. Edwards and Magee advise that any combination is possible, but it's more common to see multiple head and shoulders with a bottom rather than a top.
A common version of a multiple head and shoulders pattern includes two left shoulders of more or less equal size, one head, and then two right shoulders that mimic the size and shape of the left shoulders.
Flat Shoulders
The classic head and shoulders pattern is made up of three sharply pointed components - the head and two shoulders. This is not always the case. Sometimes, the shoulders can lack sharp low points and instead be quite rounded. This does not affect the validity of the pattern. "The point to note," explains Schabacker, "is simply that the stock is trying to continue its previous main movement but is restrained from doing so on successive occasions by the development of technical power or pressure in the opposite direction
The double top and the double bottom formations represent another well-known pair of trend reversal patterns that are commonly found on forex charts.
Double Top Trend Reversal Pattern
The double top reversal pattern is characterized as being highly reliable and can be found at the peaks of an upward trend. It includes two tops that have approximately equal heights and depicts the following currency price movement:
The currency price rises to a peak, which when reached faces resistance and then a drop to a level of support follows.
Another peak at the same level as the previous one follows, and then another drop.
A resistance line connects the two tops and a line parallel to it (a support line) is drawn. The double top chart pattern is considered confirmed and complete when the price drops below the support level, thus marking the reversal of the upward trend.
In order for this formation to successfully develop, the break through the support line should occur under the condition of a heavy market volume. Additionally, forex traders should not be alarmed if in the newly established trend a return to the new resistance level (former support level) occurs. This is known as a "throwback" move. It is considered to be a test of the reversal formation and its success helps to strengthen the pattern and the new trend.
Several weeks to several months are needed in order for the double top to develop. What is more, the intraday chart patterns are considered of a less reliable nature.
A double top occurs when prices form two distinct peaks on a chart. A double top is only complete, however, when prices decline below the lowest low - the "valley floor" - of the pattern.
The double top is a reversal pattern of an upward trend in a stock's price. The double top marks an uptrend in the process of becoming a downtrend.
Sometimes called an "M" formation because of the pattern it creates on the chart, the double top is one of the most frequently seen and common of the patterns. Because they seem to be so easy to identify, the double top should be approached with caution by the investor.
According to Schabacker, the double top is a "much misunderstood formation." Many investors assume that, because the double top is such a common pattern, it is consistently reliable. This is not the case. Schabacker estimates that probably not more than a third of them signal reversal and that most patterns which an investor might call a double top are not in fact that formation. Bulkowski estimates the double top has a failure rate of 65%. If an investor waits for the breakout, however, the failure rate declines to 17%.
The double top is a pattern, therefore, that requires close study for correct identification.
What does a double top look like?
As illustrated below, a double top consists of two well-defined, sharp peaks at approximately the same price level. A double top occurs when prices are in an uptrend. Prices rise to a resistance level, retreat, return to the resistance level again before declining.
The two tops should be distinct and sharp. The pattern is complete when prices decline below the lowest low in the formation. The lowest low is called the confirmation point.
Analysts vary in their specific definitions of a double top. According to some, after the first top is formed, a reaction of at least 10% should follow. That decline is measured from high to low.
According to Edwards and Magee, there should be at least a 15% decline between the two tops, on diminishing activity. The second rally back to the previous high (plus or minus 3%) should be on lower volume than the first. Other analysts maintain that the decline registered between the two tops should be at least 20% and the peaks should be spaced at least a month apart.
There are a few points of agreement, however. Investors should ensure that the pattern is in fact comprised of two distinct tops and that they should appear near the same price level. Tops should have a significant amount of time between them -ranging from a few weeks to a year. Investors should not confuse a consolidation pattern with a double top. Finally, it is crucial to the completion of the reversal pattern that prices close below the confirmation point.
Why is this pattern important?
According to Murphy, the double top is one of the most frequently seen and most easily recognized. However, analysts agree that this can be a difficult pattern to correctly identify. Investors must pay close attention to the volume during the formation of the pattern, the amount of decline between the two peaks, and the time the pattern takes to develop on the chart.
A double top often forms in active markets, experiencing heavy trading. A stock's price heads up rapidly on high volume. Demand falls off and price falls, often remaining in a trough for weeks or months. A second run-up in the price occurs taking the price back up to the level achieved by the first top. This time volume is heavy but not as heavy as during the first run-up. Stock prices fall back a second time, unable to pierce the resistance level. These two sharp advances with relatively heavy volume have exhausted the buying power in the stock. Without that power behind it, the stock reverses its upward movement and falls into a downward trend.
Is volume important in a double top?
Investors should pay close attention to volume when analyzing a double top.
Generally, volume in a double top is usually higher on the left top than the right. Volume tends to be downward as the pattern forms. Volume does, however, pick up as the pattern hits its peaks. Volume increases again when the pattern completes, breaking through the confirmation point. .
Monitoring volume is a key aspect of determining whether or not a double top is valid. Schabacker insists that the volume rule must be applied quite strictly in the case of a double top. The first top must be made with noticeably high volume. The second top must also experience high volume but it need not achieve the level of the first top. In fact, Schabacker points out that the second top is often made on only a slight increase over the average volume during the interval between the tops.
Bulkowski explains that volume does not need to be high on the breakout. When a breakout occurs with high volume, however, prices tend to decline further.
Elaine Yager, Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors, notes that the right-hand side of the pattern is the area to watch most closely. She watches for diminishing volume until the confirmation point at which point the volume should increase. However, Yager notes that this pattern is often traded with or without the volume increase on the right hand peak.
What are the details that I should pay attention to in the double top?
1. Uptrend Preceding Double Top
As mentioned previously, the double top is a reversal formation. It begins with prices in an uptrend. Analysts focus on specific characteristics of that uptrend when searching for a valid double top. The trend upwards should be fairly long and healthy. Bulkowski maintains that an investor will want to see prices trending up over the short to intermediate term - approximately 3 to 6 months. Further, he states that "the price trend should not be a retrace in an extended decline but generally has a stair-step appearance." Schabacker confirms this approach, explaining that if the stock has been in a long, healthy uptrend, the double top is more likely to develop into a reversal. If the uptrend is short, the double top may not hold and the uptrend will continue.
2. Time between Tops
Analysts pay close attention to the "size" of the pattern - the duration of the interval between the two tops. Generally, the longer the time between the two tops, the more important the pattern as a good reversal. Schabacker warns investors off of a pattern where only a few days intervene between the two peaks. Analysts suggest that investors should look for patterns where at least one month elapses between the peaks. It is not unusual for a few months to pass between the dates of the two tops. Murphy mentions that these patterns can span several years.
On the other hand, Yager notes that patterns that are too long may be unmanageable, and she looks for tighter, shorter patterns. Yager believes that shorter patterns are viable as long as you can see the volume in the right top forming.
3. Decline from First Top
According to Schabacker, this element is even more significant to the validity of a double top than volume. He argues the decline in price that occurs between the two peaks should be consequential, amounting to approximately 20% of the price. In fact, he states that it could even be more than that but should not be much less.Other analysts are not so definite or demanding concerning the price decline. For some, including Yager, a decline of at least 10% is adequate. All agree, however, that the deeper the trough between the two tops, the better the performance of the pattern.
4. Volume
As mentioned previously, volume tends to be heaviest during the first peak, lighter on the second. It is common to see volume pick up again at the time of breakout.
5. Decisive Breakout
According to Murphy, the technical odds usually favor the continuation of the present trend.This means that it is perfectly normal market action for prices on an uptrend to peak at a resistance level a couple of times, retreat, and then resume that uptrend. It is a challenge for the analyst to determine whether the decline from a peak is the indication of the development of a valid double top or simply a temporary setback in the progression of a continuing uptrend.Analysts, therefore, advise cautious investors to wait for the price to fall back and break through the confirmation point before relying on the validity of the pattern.
Many experts maintain that an investor should wait for a decisive breakout, confirmed by high volume. Others, like Bulkowski, are not so reliant on high volume at the time of breakout but do agree that the higher the volume at the time of breakout, the further the decline in prices that the pattern will register.
6. Pullback after Breakout
A pullback after the breakout is usual for a double top. Bulkowski argues that the higher the volume on the breakout, the higher the likelihood of a pullback. "When everyone sells their shares soon after a breakout, what is left is an unbalance of buying demand (since the sellers have all sold), so the price rises and pulls back to the confirmation point."
How can I trade this pattern?
Begin by calculating the target price -- the minimum expected price move. The double top is measured in a way similar to that for the head and shoulders top.
Calculate the height of the pattern by subtracting the lowest low from the highest high in the formation. Then, subtract the height of the pattern from the lowest low. In other words, an investor can expect the price to move downwards at least the distance from the breakout point less the height of the pattern.
For example, assume the lowest low of the double top is 230 and the highest high is 260. The height of the pattern equals 30 (260 - 230 = 30). The minimum target price is 200 (230 - 30 = 200).
Given the sometimes weak performance of the double top, Bulkowski suggests dividing the height in half before subtracting from the breakout point. In the above example, this would mean a target price of 215 (230 - 15 = 215).
Murphy cautions the term "double top" is greatly overused in the markets. Most of the patterns referred to as double tops are, in fact, something else. Because of this, Murphy advises investors to make their investment decisions only after prices have broken through the confirmation point, completing the reversal pattern.Watching the volume throughout the development of the pattern can help determine whether the pattern is a valid double top.
Edwards and Magee explain that patterns where the tops are close together in time are likely not valid double tops but are, in fact, a consolidation area.
Generally, analysts like to see deep troughs between the two peaks. Bulkowski advocates a valley that is at least 15% lower than the peaks.
Because so many double tops pullback after breaking through the confirmation point, it is often possible to wait for the pullback to place a trade and then watch prices decline for a second time.
Are there variations in the pattern that I should know about?
1. Two Peaks at Different Levels
Sometimes the two peaks comprising a double top are not at exactly the same price level. This does not necessarily render the pattern invalid. Murphy points out that investors should be less concerned if the second peak does not hit the high of the first peak. If the second peak is higher than the first, however, investors should show caution because the pattern may be in the process of resuming its uptrend. Analysts advise that if the second peak exceeds the first by more than 3%, the pattern may not be a double top. Similarly, if the second peak stays higher than the first peak by more than a couple of days, then the pattern may not be a true double top.
Double Bottom Trend Reversal Pattern
A mirror image of the double top formation is the double bottom chart pattern. This means that the same characteristics as well as potential draw
As in the double top, large market volume is required. Additionally, a relationship between the length of time needed for the double top or double bottom to develop and the significance of the reversal pattern exists.
A double bottom occurs when prices form two distinct lows on a chart. A double bottom is only complete, however, when prices rise above the high end of the point that formed the second low.
The double bottom is a reversal pattern of a downward trend in a stock's price. The double bottom marks a downtrend in the process of becoming an uptrend.
Double bottoms are often seen and are considered to be among the most common of the patterns. Because they seem to be so easy to identify, the double bottom should be approached with caution by the investor.
According to Schabacker, the double bottom is a "much misunderstood formation." Many investors assume that, because the double bottom is such a common pattern, it is consistently reliable. This is not the case. Bulkowski estimates the double bottom has a failure rate of 64%, which he terms surprisingly high. If an investor waits for a valid breakout, however, the failure rate declines to 3%.
The double bottom is a pattern, therefore, that requires close study for correct identification.
What does a double bottom look like?
A double bottom consists of two well-defined lows at approximately the same price level. Prices fall to a support level, rally and pull back up, then fall to the support level again before increasing.
The two lows should be distinct. According to Edwards and Magee, the second bottom can be rounded while the first should be distinct and sharp.The pattern is complete when prices rise above the highest high in the formation. The highest high is called the confirmation point.
Analysts vary in their specific definitions of a double bottom. According to some, after the first bottom is formed, a rally of at least 10% should follow. That increase is measured from high to low. According to Edwards and Magee, there should be at least a 15% rally following the first bottom. This should be followed by a second bottom. The second bottom returning back to the previous low (plus or minus 3%) should be on lower volume than the first. Other analysts maintain that the rise registered between the two bottoms should be at least 20% and the lows should be spaced at least a month apart.
There are a few points of agreement, however. Investors should ensure that the pattern is in fact comprised of two distinct bottoms and that they should appear at or near the same price level. Bottoms should have a significant amount of time between them - ranging from a few weeks to a year depending on whether an investor is viewing a weekly chart or a daily chart. Investors should not confuse a consolidation pattern with a double bottom. Finally, it is crucial to the completion of the reversal pattern that prices close above the confirmation point.
Why is this pattern important?
According to Murphy, the double bottom is one of the most frequently seen and most easily recognized. However, analysts agree that this can be a difficult pattern to correctly identify. Investors must pay close attention to the volume during the formation of the pattern, the amount of increase between the two lows, and the time the pattern takes to develop on the chart.
Murphy explains that bottoming patterns may have smaller price ranges than topping patterns and often take longer to build. "For this reason, it is usually easier and less costly to identify and trade bottoms than to catch market tops."
It is quite common after prices reach a new low for a rebound in prices to occur. A retest of the low then usually follows. According to Bulkowski, a retest occurs when prices return to the low and test to see if the stock can support itself at that price level. "If it cannot, prices continue moving downward. Otherwise, the low usually becomes the end of the decline and rising prices result."
Is volume important in a double bottom?
Investors should pay close attention to volume when analyzing a double bottom.
Generally, volume in a double bottom is usually higher on the left bottom than the right. Volume tends to be downward as the pattern forms. Volume does, however, pick up as the pattern hits its lows. Volume increases again when the pattern completes, breaking through the confirmation point.
Monitoring volume is a key aspect of determining whether or not a double bottom is valid. Schabacker insists that the volume rule must be applied quite strictly in the case of a double bottom. Elaine Yager,
Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors, strongly agrees with this point. The first low must be made with noticeably high volume. The second low must also experience high volume but it need not achieve the level of the first low.
Bulkowski explains that volume tends to rise substantially at the time of breakout.
What are the details that I should pay attention to in the double bottom?
1. Downtrend Preceding Double Bottom
As mentioned previously, the double bottom is a reversal formation. It begins with prices in a downtrend. Bulkowski cautions that on their way down, prices should not drift below the left low of the pattern.
2. Time between Bottoms
Analysts pay close attention to the "size" of the pattern - the duration of the interval between the two lows. Generally, the longer the time between the two lows, the more important the pattern as a good reversal. Schabacker warns investors off of a pattern where only a few days intervene between the two lows.Analysts suggest that investors should look for patterns where at least one month elapses between the bottoms. It is not unusual for a few months to pass between the dates of the two bottoms. Murphy mentions that these patterns can span several years.Yager notes, however, that tracking of bottoms that run for several years can become cumbersome and difficult. Bulkowski suggests that best gains come from formations where bottoms are approximately 3 months apart.
3. Increase from First Low
Some analysts argue the increase in price that occurs between the two bottoms should be consequential, amounting to approximately 20% of the price. Other analysts are not so definite or demanding concerning the price increase. For some, an increase of at least 10% is adequate. Yager strongly agrees with this point. The rise between the lows tends to look rounded but it can also be irregular in shape.
4. Volume
As mentioned previously, volume tends to be heaviest during the first low, lighter on the second. It is common to see volume pick up again at the time of breakout.
5. Decisive Breakout
According to Murphy, the technical odds usually favor the continuation of the present trend. This means that it is perfectly normal market action for prices on a downtrend to fall to a support level a couple of times, rise back up, and then resume that downtrend. It is a challenge for the analyst to determine whether the rise from the bottom is the indication of the development of a valid double bottom or simply a temporary setback in the progression of a continuing downtrend.Analysts, therefore, advise cautious investors to wait for the price to rise back up and break through the confirmation point before relying on the validity of the pattern. Many experts will maintain that an investor should wait for a decisive breakout, confirmed by high volume.
6. Pullback after Breakout
A pullback after the breakout is usual for a double bottom. Bulkowski estimates that in 68% of double bottom patterns, price will throwback to the breakout price.
How can I trade this pattern?
Begin by calculating the target price -of the minimum expected price move. The double bottom is measured in a way similar to that for the head and shoulders bottom.
Calculate the height of the pattern by subtracting the lowest low from the highest high in the formation. Then, add the height of the pattern to the highest high. In other words, an investor can expect the price to move upwards at least the distance from the breakout point plus the height of the pattern.
For example, assume the lowest low of the double bottom is 220 and the highest high is 290. The height of the pattern equals 70 (290 - 220 = 70). The minimum target price is 360 (290 + 70 = 360).
Murphy cautions the terms "double tops and bottoms" are greatly overused in the markets. Most of the patterns referred to as double bottoms are, in fact, something else. Because of this, Murphy advises investors to make their investment decisions only after prices have broken through the confirmation point, completing the reversal pattern.Watching the volume throughout the development of the pattern can help determine whether the pattern is a valid double bottom.
Yager notes that the key for this pattern is for the investor to have patience and wait for confirmation. Too often investors see double bottoms everywhere.
Edwards and Magee explain that patterns where the bottoms are close together in time are likely not valid double bottoms but are, in fact, a consolidation area.
Because so many double bottoms pullback after breaking through the confirmation point, it is often possible to wait for the pullback to place a trade and then watch prices decline for a second time.Bulkowski estimates that the average time for prices to return to the breakout price is 11 days. Throwbacks that occur 30 days after the breakout are not throwbacks at all, but simply normal price fluctuations.
Bulkowski offers advice for both short-term and long-term investors. Because only approximately 68% of double bottoms meet their price targets, he advises short-term investors to be ready to take profits as price nears the target. In other words, sell as prices get close to the target.Long-term investors, he suggests, can hold onto the stock for an extended upward move but should keep watch on the fundamentals to determine whether they are justified in continuing to hold the stock.
Are there variations in the pattern that I should know about?
Two Lows at Different Levels
Sometimes the two lows comprising a double bottom are not at exactly the same price level. This does not necessarily render the pattern invalid. Analysts advise that if the second low varies in price from the first low by more than 3% or 4%, the pattern may not be a double bottom.
It is worth remembering that the major trend reversal patterns are:
The head-and-shoulders and the inverted head-and-shoulders
The double top and the double bottom
The triple top and the triple bottom
This article considers the last pair - the triple top and the triple bottom formations.
Triple Top Trend Reversal Pattern
The triple top chart pattern represents a combination of the head-and-shoulders and the double-top trend reversal formations. As a result, the same characteristics as well as possible drawbacks and signals are possessed by the triple top as observed in the double top and head-and-shoulders.
The triple top formation consists of three tops that have almost the same altitude and depicts the following currency price movement:
The first step is the creation of a new peak in the uptrend movement of the price which faces resistance and causes the price to fall to a level of support.
Another rise of the price to the level of resistance follows, and then another fall to the support level.
The price rises for a third time only to fall again, this time through the level of support.
The three peaks are connected by a line (the support line) and a line parallel to it (the resistance line) is drawn.
Just as with the other major trend reversal patterns large market volume should accompany the price movement when it breaks below the support level.
A triple top is considered to be a variation of the head and shoulders top. Often the only thing that differentiates a triple top from a head and shoulders top is the fact that the three peaks that make up the triple top are more or less at the same level. The head and shoulders top displays a higher peak - the "head" - between the two shoulders.
According to experts including Murphy, making a distinction between these two patterns is largely academic because they both imply the same thing. They are both "reversal" patterns of an upward trend in a stock. The triple top marks an uptrend in the process of becoming a downtrend. What does a triple top look like?
As shown below, the triple top pattern is comprised of three sharp peaks, all at the same level. A triple top occurs when prices are in an uptrend. Prices rise to a resistance level, retreat, return to the resistance level again, retreat, and finally, return to that resistance level for a third time before declining. In a classic triple top, the decline following the third peak marks the beginning of a downtrend.
While the three peaks should be sharp and distinct, the lows of the pattern can appear as rounded valleys. The pattern is complete when prices decline below the lowest low in the formation. The lowest low is also called the "confirmation point."
Bulkowski advises that this pattern can have many variations. He continues, however, to advise that an investor should ensure that the three peaks are well separated and not part of a congestion pattern. "Each top should be part of its own minor high, a distinct peak that towers about the surrounding price landscape."
Elaine Yager, Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors suggests they should be noticeably distinct peaks and they do not have to be precisely at the same level. Why is this pattern important?
Like the head and shoulders top which it resembles so closely, the triple top is considered by experts to be a reliable pattern. According to Schabacker, there is a good explanation for placing reliance on this pattern. The pattern illustrates three successive attempts to break through a resistance level. Price cannot move above a certain point, despite three tries. "Each failure adds weight to the indications of reversal," explains Schabacker. Is volume important in a triple top?
Generally, volume in a triple top tends to be downward as the pattern forms. Murphy advises that volume should be lighter on each rally peak. Volume then picks up as prices fall under the confirmation point and break into the new downward trend.
Both Bulkowski and Schabacker place less significance on the downward progression of volume. While both agree that investors should see relatively high volume on the first peak, they also agree that volume on the other peaks can be confused and irregular.
Volume should be higher on the peaks than at the lows. Bulkowski's statistics suggest that an investor should see a volume burst at the time of breakout and during the few days following the decline in price below the confirmation point. What are the details that I should pay attention to in the triple top?
1. Duration of the Pattern
This pattern can take upwards of several months to form. According to Bulkowski, average formation time is approximately four months. In addition, experts, including Schabacker and Murphy, agree that the longer the pattern takes to form, the greater the significance of the price move once breakout occurs. The three highs do not need to be equally spaced from one another.
2. Need for an Uptrend
The triple top is a reversal pattern marking the transition period between an uptrend and a downtrend in prices. It is crucial to the existence of this pattern that it begin with an uptrend of stock prices.
3. Decisive Breakout
Investors are advised to wait for prices to make a definitive
break below the confirmation point of a triple top pattern. If prices do not fall below the confirmation point after the third peak is reached, the pattern is not a triple top. In a bull market, for example, it is common to see three highs which look like the beginning of a well-formed triple top. If prices, however, do not fall below the confirmation point, they can just as easily pull away from the highs established by the three peaks and then continue on in the upward trend.
4. Volume
As discussed, it is typical to see
volume diminish as the pattern progresses. This should change, however, when breakout occurs. A valid breakout should be accompanied by a burst in volume. Certain experts are less concerned by seeing a steadily diminishing trend in volume as the pattern progresses through its three highs. Schabacker comments that the volume picture can often be confused and irregular. All agree, however, that an investor will want to see a definite increase in volume at the time of the break through the confirmation point.
5. Rally after Breakout
Yager notes that a high percentage
of triple tops have rallies back to the point of the breakdown more often than not.
How can I trade this pattern?
Begin by calculating the target price - the minimum expected price move. The triple top is measured in a way similar to that for the head and shoulders top.Calculate the height of the pattern by subtracting the lowest low from the highest high in the formation. Then, subtract the height from the lowest low. In other words, an investor can expect the price to move downwards at least the distance from the breakout point less the height of the pattern.
For example, assume the lowest low of the triple top is 170 and the highest high is 220. The height of the pattern equals 50 (220 - 170 = 50). The minimum target price is 120 (170 - 50 = 120).
Bulkowski calculates that the measure rule is not completely reliable for the triple top, estimating that nearly 50% of all triple tops will fall short of their minimum target price.
Edwards and Magee warn that true triple tops are few and far between. So, it makes sense to be cautious when assessing what might initially look like a developing triple top.
According to Edwards and Magee, an investor should never "jump the gun" with a triple top. If the triple top is not completed by breaking through the confirmation point, experts advise caution. The pattern can fail to complete and just as easily recommence an upwards trend. However, Edwards and Magee also explain that if the pattern has been confirmed by a valid breakout, then the pattern seldom fails.
"Stick to the breakout rule," they advise, "and you will be safe."
Rallies are common with triple tops. An investor can trade that return move to his or her advantage. According to Bulkowski, if an investor misses the breakout, there's still time to place or add to a short position when prices resume their rally towards the former breakdown level. In this case it would have been 170.
Are there variations in the pattern that I should know about?
1. Hybrid Variation
There is a hybrid variation that appears to be a cross between a double and triple top. The middle peak is slightly lower than the left and right peaks. This is still a valid reversal pattern.
2. Fourth Peak
It is possible for the pattern to display a fourth peak before reversal occurs.
Triple Bottom Trend Reversal Pattern
A combination of the inverted head-and-shoulders and the double bot
tom reversal formations gives the triple bottom, which is a mirror image of the triple top pattern. Again, this means that the same characteristics, potential drawbacks, signals, as well as trader's point of view can be referred to the triple bottom chart pattern.
A triple bottom pattern displays three distinct minor lows at approximately the same price level. The triple bottom is considered to be a variation of the head and shoulders bottom. Like that pattern, the triple bottom is a reversal pattern.
The only thing which differentiates a triple bottom from a head and shoulders bottom is the lack of a "head" between the two shoulders. The triple bottom illustrates a downtrend in the process of becoming an uptrend. It is, therefore, vital to the validity of the pattern that it commence with prices moving in a downtrend.
Elaine Yager, Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors goes further to say that this pattern must commence with prices moving in a major downtrend - one that has lasted for one year or more.
What does a triple bottom look like?
As illustrated below, the triple bottom patte
rn is composed of three sharp lows, all at about the same price level. Prices fall to a support level, rise, fall to that support level again, rise, and finally fall, returning to the support level for a third time before beginning an upward climb. In the classic triple bottom, the upward movement in the price marks the beginning of an uptrend.
Investors should note that the three lows tend to be sharp. When prices hit the first low, sellers become scarce, believing prices have fallen too low. If a seller does agree to sell, buyers are quick to buy at a good price. Prices then bounce back up. The support level is established and the next two lows also are sharp and quick. Bulkowski points out that the sharp lows are often only one-day spikes.
While the three lows should be sharp and distinct, the highs of the pattern can appear to be rounded. The pattern is complete when prices rise about the highest high in the formation. The highest high is called the "confirmation point."
This pattern, the experts warn, can be easily confused with other similar patterns. For example, if the center low is lower than the other two, the pattern may be a head and shoulders bottom. Also, if the three bottoms are successively higher or lower than one another, the pattern may be a triangle formation.
Because the pattern is easy to confuse, an investor should look for three sharp lows which are well separated and not part of a larger congestion pattern. In addition, between the lows, the highs should be fairly rounded in shape, although it is not absolutely necessary to the validity of the pattern. If the pattern fails to move up and break through the confirmation point after reaching the third low, the pattern is not a valid triple bottom.
Why is this pattern important?
Like the head and shoulders bottom which it so closely resembles, the triple bottom is considered to be a reliable pattern. Bulkowski estimates the failure rate to be a low 4%, assuming that an investor waits for the upside breakout through the confirmation point.
Is volume important in a triple bottom?
Generally, volume in a triple bottom tends to trend downward as the pattern forms. Volume tends to be lighter on each successive low. Volume then picks up as prices rise above the confirmation point and break into the new upward trend.
An investor should not dismiss a triple bottom if volume does not display this pattern. The pattern can take several months to form and, during that time, volume can be irregular and unpredictable. Volume should be higher at the lows than on the days leading to the lows.
What are the details that I should pay attention to in the triple bottom?
1. Duration of the Pattern
The average formation takes approximately four months to develop. The triple bottom is one of the longer patterns to develop. Schabacker and Murphy agree, however, that the longer the pattern takes to form, the greater the significance of the price move once breakout occurs.
2. Need for a Downtrend
The triple bottom is a reversal pattern. This means it is essential to the validity of the pattern that it begin with a downward trend in a stock's price. As Yager noted above, some experts believe the downtrend must be a major one.
3. Decisive Breakout
Because a triple bottom can be confused with many other patterns as it is developing, experts advise that investors wait for a valid breakout through the confirmation point before deciding whether the pattern is a true triple bottom. Bulkowski reinforces this message, stating that true triple bottoms are quite rare and waiting for a valid breakout is essential before determining whether the pattern is a triple bottom.
4. Volume
As discussed, it is typical to see volume diminish as the pattern progresses. This should change, however, when breakout occurs. A valid breakout should be accompanied by a burst in volume. Certain experts are less concerned by seeing a steadily diminishing trend in volume as the pattern progresses through its three lows.
5. Pullback after Breakout
It is very common in the triple bottom to see a pullback after the breakout. Bulkowski estimates that 70% of triple bottoms will throw back to the breakout price.
How can I trade this pattern?
Begin by calculating the target price - the minimum expected price move. The triple bottom is measure in a way similar to that for the head and shoulders bottom.
Calculate the height of the pattern by subtracting the lowest low from the highest high in the formation. Then, add the height to the highest high. In other words, an investor can expect the price to move upwards at least the distance from the breakout point plus the height of the pattern.
For example, assume the lowest low of the triple bottom is 200 and the highest high is 240. The height of the pattern is 40 (240 - 200 = 40). The minimum target price is 280 (240 + 40 = 280).
Experts agree that triple bottoms are not that common. Edwards and Magee, for example, stress the necessity for waiting for a valid breakout through the confirmation point.However, this is a reliable pattern if the pattern has been confirmed by a valid breakout.
Pullbacks are common with triple bottoms. Investors can use this to their favor advises Bulkowski. If prices return to the confirmation point quickly after the breakout (within two weeks but no more than a month), Bulkowski suggests that the time to jump in is once the prices have turned around again and headed back up.
Investors looking for a valid triple bottom should be wary of a pattern that shows a lot of white space as it is developing. The pattern should display a fairly regular progression among the three, well-separated lows. Yager suggests that the symmetry of this pattern is something that should catch your eye.
source : http://www.recognia.com
