Thursday, March 23, 2017

Major Reversal Pattern - Double Top

This article was written in 2007. 

At every start of a major decline, it was observed that certain price patterns will occur on the chart.  They are historically proven to at least influence the immediate trend if not the mid to long term trend.  While most of the investors will be caught off guard as the downtrend persists, traders who are able to identify reversal patterns will be in a better position to avoid massive losses.  This article will discuss one of the major top reversal pattern known as the double top pattern.

As the name suggests, in-order to reverse a trend, there should be a significant uptrend prior to this reversal pattern.  The price will move to a new high and pulls back to form a trough before another peak fails near the old high of the first peak.  Many traders and investors may jump to a premature conclusion that a double top pattern has been formed.  However, a double top pattern is only considered formed after the the price has broken the support at the low of the trough between the two peaks.  There are many variations of this pattern and thus a savvy trader or investor has to be flexible in applying the techniques to identifying the pattern.  As the wise saying goes, “History likes to repeat itself, but it can repeat in many forms”
After the brief introduction to the price movement of the double top pattern, we shall now explore the technical specifics of this pattern.  There are guidelines to identify the best double top pattern. They are, prior trend, price peaks, volume, duration and support turns resistance. 
#1 Prior trend: There must be a significant uptrend prior to the double top pattern.
#2 Price peaks: The second peak will not be resisted at the first peak exactly. As a rule of thumb, the difference between the second peak and the first should be within 4%, either more or less. We should not restrict the second peak to be lower than the first peak.
#3 Volume: The average volume traded at the second peak should be lower than the first peak.  This signifies that when the market retest the old high, there is an obvious lack of participation as shown by the lower average volume.  Without strong participation, the rally in price will not sustain.

#4 Duration: The best pattern will take anything from 1 month to 3 months to form.  However, as mentioned, we should expect variations of the double top pattern and hence some may take a longer duration to form. Most importantly the essence of the formation must be present.




Figure 1: Example of a double top pattern found in STI chart.



Let us look at Figure 1 which shows a double top pattern found in STI chart.  We had a significant uptrend from the low in August which ends with the first peak formed in October.  A trough then forms in late October which leads to a price rally that took us to the second peak in early November.  However, a quick check on the average volume shows that the second peak has a lower average volume as compared to the first peak.  Once the price broke the low of the trough, the double top pattern is confirmed.  Figure 1 also shows that the formation took about one month to complete.
We can also derive price target base on the double top pattern.  This will give the trader or investor an idea of where the price is likely to head to.




Figure 2: Example of projecting a price target

As seen in Figure 2, to project the price target of a double top pattern, firstly we measure the height of the peak to the low of the trough.  Lastly, we project the height downwards from the low of the trough and derive the price target.  With the price target derived, we will know the potential decline of the price.


Figure 3: Example of support turns resistance

When the double top pattern is confirmed and price had broken the low of the trough, investors can look forward to a retest of the low of the trough as a resistance.  As seen in Figure 3, the low of the trough in May 2000 was a support before the second peak was formed.  Once broken, that support has been retested as a resistance in May 2001.  This retest if fails, offers an opportunity for investors to break jail before another leg down.

This article had discussed how to identify a double top pattern which is one of the major reversal patterns by paying attention to prior trend, price peaks, volume and duration.  We also learn how to derive price target from the pattern and look out for a retest of the low of the trough from a support as a resistance.


This article first appeared in Smart Investor in 2007. 
DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.

Thursday, March 02, 2017

Japanese Candlestick - Hammer

This article was written in 2007. 

There are many types of price charts available today and one of my favorite is the Japanese Candlestick chart.  They are very similar to bar charts except for the many reversal or continuation patterns which we can visually interpret from a group of successive candles found on the chart.  These patterns reflect the change in psychology of the traders and are useful to identify turning points on the chart.

A candlestick is made of the candle body which denotes the opening and closing price and the shadows which denote the intra-period high and the intra-period low where the period can be one hour, 1 day, one week or one month.  The color of the candlestick body tells us if the bulls or the bears won the day.  Whenever a candlestick has a white body, it means that the bulls were stronger than the bears and managed to close the price higher than the opening price.  On the other hand, a candlestick with a black body means that the bears were stronger than the bulls and managed to close the price below the opening price.  Hence, just by looking at the color of the candlestick body, we are able to deduce which side of the market has won the day.  As for the shadows (intra-period high or low), they give us a measure of how much territory the bulls and bears are willing to give to the other.  In the case of long shadows, this also often reflects that there is a sudden and abrupt change of power between the bulls and the bears.  For example, if Stock A open at $1.00 and during the trading day it went up to $1.30.  With such a surge in price, the bulls are firmly in control as many would have expected.  However, if by the closing bell, the stock price falls from the intra-day high of $1.30 to close at $1.00, this will leave a long upper shadow which starts at the candle body and ends at the intra-day high (assuming we are looking at a period of a day to draw the candlestick).  For the price to fall from its intra-day high of $1.30 to $1.00, massive selling is required.  This long upper shadow thus showed an abrupt and sudden change of powers from the bulls to the bears.  The opposite is true for the lower shadow.  In this case, the change of power is from the bears to the bulls and we get a long lower shadow.

A Hammer is formed if the lower shadow is longer by more than 2 times the candle body.  The upper shadow should be very minimal (smaller or equal to candle body) or even non existent.  It has a small candle body which is very close to the upper shadow.  Figure 1 shows an example of a Hammer pattern.


Figure 1: Example of a Hammer.

In order to use a Hammer pattern effectively, we have to identify the preceding trend before the pattern is formed.  This is because while the pattern formed after a downtrend is known as a Hammer, the same pattern can be formed after an uptrend and is known as a Hanging Man.  The interpretation is different.  When a Hammer pattern is formed, we observe that the bulls are strong and managed to beat the bears by closing the price way above the low of the day. However, when a Hanging Man is formed, we interpret the pattern differently.  We observe the long lower shadow as evidence that the bears are flexing their strength in the uptrend but the bulls still manage to stay in control and close the price way above the low during that day.  When we trade a Hammer or Hanging Man, we want to see a white confirmation candle and a black confirmation candle respectively. 

Figure 2: Hammer with white candle confirmation

As seen in Figure 2, there was a preceding downtrend before we observed that a Hammer was formed which is then followed by a white candle confirmation.  
Figure 3: Hanging Man with black confirmation


In Figure 3, the price was moving in an uptrend before being interrupted by a Hanging Man pattern.  A black confirmation candle then formed and the price began to retrace.
After learning how to interpret Hammer and Hanging Man patterns, we are going to explore another way of using this Hammer pattern to our advantage with or without the white candle confirmation.  Since Hammer and Hanging Man reflects a strong change in power between the bulls and the bears, it will be very effective if we can spot them near support or resistance levels.  These can be determined either by trend lines, Fibonacci, moving average and so on.  Alternatively, we can use an oscillator like RSI or Stochastic together with the pattern too.


Figure 4: Example of Hammer resting on support



In Figure 4, we show how to interpret a Hammer pattern together with both the 50 day moving average and the Stochastic indicator. Firstly, the price had been trading lower since early April'07 and a Hammer pattern was formed (denoted by the small arrow).  It was then observed that the end of the lower shadow sits on the 50-day moving average.  As moving average can be used as support or resistance, in this case, we say that the price is supported by 50-day moving average.  Lastly, Stochastic indicated oversold level has reached.  When the stochastic is in oversold, there is a possibility of the price moving up.  Hence with the Hammer pattern indicating a strong change in power from the bears to the bulls and with the moving average supporting the price and Stochastic indicating oversold, the probability of the price turning higher is very high.

In this article we have learnt how to interpret candlestick patterns namely Hammer and Hanging Man. Also, we have discussed how we can combine this analysis with indicators to give us an upper hand in trading.  
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This article first appeared in Smart Investor in 2007. 
DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.