Chapter 4 - Chart Formations and Projections

Question 1

What is an apex?

Answer 1

The point where two sides of a triangle converge (meet).

Question 2

What is an ascending triangle?

Answer 2

A chart formation in which the market posts steady highs and higher lows to form a triangle pattern with a flat top and a
rising side.

Question 3

What is a base?

Answer 3

The height of a triangle pattern.

Question 4

What is a bull trap?

Answer 4

A market that breaks above a significant level and generates a buy signal but fails to follow
through on the upside before turning sharply lower is referred to as a bull trap.

Question 5

What is a bear trap?

Answer 5

A market that
breaks down out of a bearish formation but fails to follow through on the downside before
turning sharply higher is referred to as a bear trap.

Question 6

What is a breakaway gap?

Answer 6

A chart formation in which prices gap out
of an area of congested trading, often
signalling the start of a major move; see gap.

Question 7

What is a broadening top?

Answer 7

A specific example of an inverted (i.e.,
expanding) triangle that is formed by five
distinct reversals or waves.

Question 8

What is a common gap?

Answer 8

A gap that often occurs in illiquid markets;
they are usually of little significance; see
gap.

Question 9

What is a continuation pattern?

Answer 9

A chart formation indicating that the current trend will continue.

Question 10

What is a descending triangle?

Answer 10

A chart formation in which the market
posts steady lows and lower highs to form a
triangle pattern with a flat bottom and a
falling side.

Question 11

What is a double bottom?

Answer 11

A chart formation that resembles a W and
can occur on a daily, weekly, or monthly
chart.

Question 12

What is a double top?

Answer 12

A chart formation that resembles an M and
can occur on a daily, weekly, or monthly
chart.

Question 13

What is an exhaustion gap?

Answer 13

Th e last gap in a trending market; see gap.

Question 14

What is a flag?

Answer 14

A chart formation in which prices move
sharply to create a near vertical line (the
flag pole) followed by a small move in the
opposite direction (the flag); support and
resistance lines within the flag should be
close to parallel; see pennant.

Question 15

What is a gap?

Answer 15

An open space on a chart where no trading
has occurred; a gap is created when the low
of one time period is above the high of the
previous period, or the high of one time
period is below the low of the previous
period.

Question 16

What is a head-and-shoulders bottom formation?

Answer 16

A formation that marks the end of a long
downtrend; prices fall to new lows and
bounce slightly to form the left shoulder;
the market then falls again to form a new
low and bounces close to the level of the
previous bounce to form the head; prices
then fall again, but to levels not as low as
the head, to form the right shoulder; when
prices rally above the neckline, the pattern
is confirmed; also known as an inverted
head-and-shoulders formation.

Question 17

What is a head-and-shoulders formation?

Answer 17

A reversal formation that looks like a head
with two shoulders; see head-and-shoulders
bottom formation and head-and-shoulders
top formation.

Question 18

What is a head-and-shoulders top formation?

Answer 18

A formation that marks the end of a long
uptrend; prices rally to new highs and pull
back slightly to form the left shoulder; the
market then rallies again to form a new
high and pulls back close to the level of the
previous retracement to form a head; prices
then rally again, but not as high as the
head, to form the right shoulder; when
prices fall below the neckline, the pattern is
confirmed.

Question 19

What is an inverted triangle?

Answer 19

A chart formation in which the market
posts higher highs and lower lows to form a
triangle pattern with increasing volatility.

Question 20

What is an island reversal?

Answer 20

A chart formation in which prices gap up
(down), trade for a period of time without
filling the gap, and then gap down (up).

Question 21

What is a key reversal?

Answer 21

A formation that marks the end of a trend;
the market starts to follow the trend
(higher highs in an uptrend, lower lows in a
downtrend) but reverses to end below the
previous period’s low in the case of an
uptrend, or above the previous period’s
high in the case of a downtrend.

Question 22

What is a pennant?

Answer 22

A chart formation in which prices move
sharply to create a near vertical line (the
flag pole) followed by a small move in the
opposite direction; support and resistance
lines within the pennant resemble a
triangle; see flag.

Question 23

What is a rounded bottom?

Answer 23

A chart formation where a downtrend
slowly gives way to an uptrend; simply a
gradual shift of control from the bears to
the bulls (also known as saucer bottom).

Question 24

What is a rounded top?

Answer 24

A chart formation where an uptrend slowly
gives way to a downtrend; simply a gradual
shift of control from the bulls to the bears
(also known as saucer top).

Question 25

What is a runaway gap?

Answer 25

A gap or series of gaps that follow a
breakaway gap; see gap.

Question 26

What is a symmetrical triangle?

Answer 26

A chart formation in which the market
posts lower highs and higher lows to form a
triangle pattern with equal sides and slopes.

Question 27

What is a triangle?

Answer 27

A chart formation; see symmetrical triangle,
ascending triangle, and descending triangle.

Question 28

What is a V bottom?

Answer 28

A chart formation that signals an abrupt
end to a downtrend; prices spike lower,
reverse, and spike up, leaving a “V”-like
pattern behind.

Question 29

What is a V top?

Answer 29

A chart formation that signals an abrupt
end to an uptrend; prices spike higher,
reverse, and spike down, leaving a “V”-like
pattern behind.

Question 30

What is a wedge?

Answer 30

A chart formation that is similar to a
symmetrical triangle, except for the presence
of a rising (in the case of a rising wedge) or
falling (falling wedge) slant.

Question 31

Explain the concept of key reversals.

Answer 31

• A key reversal occurs when a single bar on a daily, weekly or monthly chart is
  characterized by a new high (low) during an uptrend (downtrend) and a close lower
  (higher) than the previous period’s close.
• If both the high and low range are outside the previous period’s range, the pattern is
  called an outside day (or week, or month).
• Volume on key reversals is typically heavy and above average.
• Key reversals accompanied by heavy volume are very good signals of a trend reversal,
  although as with most other reversal indicators, confirmation should be obtained from
  other sources.
• Trading key reversals can be done in the following three ways:
  – In the first method, aggressive, high risk tolerant trades can be entered after the
  reversal day (or week), with protective stops placed just beyond the high (for
  reversal tops) or low (for reversal bottoms).
  – A second method is to enter the trade after the market has moved back toward the
  reversal high or low, and the same protective stops can be used.
  – A third approach is to wait until the trendline is, in fact, broken before establishing
  a new position.

Question 32

Explain the concept of head-and-shoulders formations.

Answer 32

• There are two types: the head-and-shoulders top and the head-and-shoulders bottom.
• Both are often interpreted as the last phase of a trending market.
• Head-and-shoulders formations have the following four parts:
  – left shoulder
  – head
  – right shoulder
  – neckline
• Volume also plays a significant role when interpreting head-and-shoulders formations.
• After making a new high (low) in an uptrend (downtrend), prices retrace somewhat
  before resuming their previous trend to a higher high (lower low), forming the left
  shoulder and the left half of the head. Volume during this second push is usually lower
  than that on the first move.
• This second new high (low) is followed by a retracement to around the low (high)
  between the left shoulder and the now completed head. A third move up (down)
  follows, although a new high (low) is not made (this completes the right shoulder).
  Volume during this third move is lower than the volume on the previous two moves.
• As the price retreats (advances) from the right shoulder, the formation is complete
  when it breaks the neckline. A pickup in volume is usually noticed when the neckline is
  broken.
• Ways to estimate the expected move include:
  – adding or subtracting the distance from the neckline to the top of the head to the
  breakout of the neckline; and
  – adding the width from shoulder to shoulder to the breakout of the neckline.
• Two primary ways of trading a head-and-shoulders formation are as follows:
  – A stop order can be placed just beyond the neckline to establish a position once the
  pattern is finished.
  – A stop can be placed just beyond the neckline after it has been broken in hope of
  catching the retest back to the neckline. As always, a position can be scaled into by
  using a combination of these two techniques.

Question 33

Explain the concept of double tops and bottoms.

Answer 33

• Double tops and bottoms tend to develop over two months or less on a daily chart, and
  much longer on a weekly or monthly chart.
• After establishing a new high (low), prices rebound before rising (falling) back to the
  area of the new high (low).
• If that high (low) is not exceeded, and the market starts to reverse direction again, there
  is a chance that the market is putting in a double top (bottom).
• If the market breaks through the rally low (high), a double top (bottom) has formed,
  with the final breakout usually accompanied by increased volume.
• Potential double tops and bottoms can be traded in the following two ways: first, once
  the formation is complete, a purchase can be made below (above) the break; second,
  as the market moves towards completion of the formation, it will often break a longer-
  term trendline and a position can be entered here.

Question 34

Explain the concept of rounded tops and bottoms.

Answer 34

• These represent a gradual shift of control from one market bias to another, and they
  usually evolve over long periods of time.
• They tend to be very difficult to trade.

Question 35

Explain the concept of V formations.

Answer 35

• Unlike rounded tops and bottoms, V formations tend to occur quite abruptly.
• The magnitude of the reversal is usually very violent, often retracing much of the
  previous trend.
• V formations usually comprise a key reversal or an island reversal.
• It is very hard to time a V formation reversal, but the existence of a key reversal or an
  island reversal are good indications that a trend is about to reverse.

Question 36

Explain the concept of symmetrical triangles.

Answer 36

• A symmetrical triangle is usually a continuation pattern, but can be a reversal pattern.
• It represents a symmetrical narrowing of prices, with lower highs and higher lows, to
  an apex.
• It is important to watch the market action closely as prices approach the apex, since
  false breakouts occur.
• If the trend in the direction of the breakout does not continue within a few days (periods) of the
  breakout, the move is likely a false breakout!!!
• As the triangle develops, stop orders can be placed on either side of the potential
  breakout to enter a trade. Alternatively, a position can be established once the breakout
  has occurred and the direction has been confirmed with an increase in volume.
• The estimated move on the breakout is equal to the height of the base of the triangle.

Question 37

Explain the concept of ascending triangles.

Answer 37

• An ascending triangle is a bullish pattern consisting of a flat top representing resistance
  and a trendline connecting a series of higher lows.
• Ascending triangles are normally continuation patterns in bull markets, but are reversal
  patterns at market lows.
• Confirmation with volume is not as important as it is with a symmetrical triangle.
• Once the upper resistance is broken, buy orders can be placed, with the use of
  protective stops either just below the ascending trendline or just below the most
  previous reaction low.
• The measured move is the height of the base of the formation, and is dependent on the
  length of time over which the pattern has formed.

Question 38

Explain the concept of descending triangles.

Answer 38

• A descending triangle is the exact opposite and bearish equivalent of an ascending
  triangle, consisting of a flat bottom representing support and a descending trendline
  connecting lower highs.
• Descending triangles are continuation patters in bearishly trending markets, and are
  reversal patterns when they occur at market tops.
• The trading strategy is the exact opposite of the ascending triangle’s strategy.
• The measured move is similar to that of the ascending triangle.

Question 39

Explain the concept of inverted triangles and broadening tops.

Answer 39

• Inverted triangles are major topping patterns that are made up of a series of reversals,
  with each reversal exceeding the last.
• There is no measured move, but a reversal of around 62% or more of the previous bull
  market can be expected.

Question 40

Explain the concept of wedges.

Answer 40

• Wedges can be either rising or falling.
• Regardless of where they occur, a rising wedge is always bearish and a falling wedge is
  always bullish.
• There is no specific measured move, but an estimate can be made by adding (or
  subtracting) the height of the preceding rally to either the apex of the wedge or the
  breakout point.

Question 41

Explain the concept of flags and pennants.

Answer 41

• These are always expected to be continuation patterns.
• Flags resemble small trend channels; pennants resemble small triangles.
• The best way to trade is to wait for the breakout and take a position according to the
  direction of the primary trend.
• The measured move is directly proportional to the height of the pole supporting the
  formation.

Question 42

What reversal patterns did you learn in this chapter?

Answer 42

• key reversals
• head-and-shoulders top formations
• head-and-shoulders bottom formations
• double tops and bottoms
• rounded tops and bottoms
• V formations
• island reversals

Question 43

What are the four parts of a head-and-shoulders formation?

Answer 43

1. Left shoulder: This part of the pattern is not evident until the right shoulder is beginning to
   be formed.
2. Head: This is the extreme top of the formation. It can be noticed if the subsequent decline
   that completes the head formation declines below the peak of the left shoulder and equals,
   or comes very close to, the bottom of the left shoulder.
3. Right shoulder: Th is is the key to the pattern because it is the right shoulder that defines
   the formation. The right shoulder should be similar to the left shoulder in height and
   length.
4. Neckline: Th is is a line drawn across the troughs of the left and right shoulders. Typically,
   the line should have a slight positive slope, but it is not an absolute necessity. In the above
   example the line is actually flat. The breaking of the neckline is what completes the pattern.

In addition, volume should follow a certain pattern in order for the formation to have the
highest probability of signalling a successful reversal pattern. As a general rule, volume during the
formation of the head is less than during the formation of the left shoulder, indicating diminishing buying pressure (demand). As well, volume during the formation of the right
shoulder is noticeably lighter than during the previous two peaks. When the neckline is broken,
volume tends to pick up.

Question 44

What are the parts of a head-and-shoulders bottom formation?

Answer 44

1. Th e neckline is usually downward sloping, whereas for the top formation it is usually
   upward sloping.
2. Th e patterns generally take longer to form and the reversals take longer to reach their targets. THE MARKET TAKES THE STAIRS UP AND THE EXPRESS ELEVATOR DOWN.
3. Volume confirmations are generally more important on bottoming formations than they
   are for tops. This is because, at bottoms, markets require a significant increase in buying
   pressure to rebound and begin moving higher. It is essential that, when prices break over the
   neckline of a head and shoulder bottom, volumes increase. If they do not, the formation has
   a greater chance of failing.

Question 45

Why use the head-and-shoulders pattern?

Answer 45

1. measurable price objective
2. defined entry point
3. defined stop loss point

Question 46

Using the head-and-shoulders bottom as an example, what are three methods of trading this formation?

Answer 46

1. Place a buy stop order above the neckline to take advantage of the first sign that the pattern
   is complete. The stop loss point would be somewhere below the neckline (3% is often used).
   A technician may want to make both orders stop close only, because an inter-day break of
   the neckline is not considered as significant as a closing break.
2. Once the neckline breaks, the market, after rallying to approximately the length of the right
   shoulder, will very often correct back and retest the neckline to validate the break before
   the market completes the measured move. Place buy stop orders just above the neckline,
   and place stop loss orders somewhere below the neckline. The risk in this approach is
   that prices may not return to the neckline and the trade may be missed. In the example
   shown in Figure 4.4, prices did correct back towards the neckline creating an ideal buying
   opportunity.
3. A combination of the two techniques can be used to scale into a position. Half the position
   may be established when the break first occurs, and if prices move back to the neckline, the
   second half can be established, therefore at least a partial long position is guaranteed.

Question 47

What are the four types of gaps?

Answer 47

1. Common gap: A gap on a chart that is typically created by normal illiquid markets. These
   gaps have little or no significance.
2. Breakaway gap: A gap formed at the end of a price pattern or breaking of a trendline.
   Breakaway gaps normally occur at the beginning of a trend and often indicate the beginning
   of a major market move. Figure 4.8 shows a gap above a small area of congestion. Typically,
   these gaps identify the beginning of a sharp move and are great trading opportunities.
   Normally, they occur on heavy volumes and are not filled. For upside breakouts, prices will
   often pull back to the top of the gap and find support there. Positions established following
   a bullish break-away gap should be protected with stop loss orders placed at the bottom of
   the gap. If the gap is filled, this is a sign of weakness and may indicate a false breakout.
3. Runaway gap: A gap or series of gaps that follow a breakaway gap. It is very difficult to
   trade a market that is running away, because you never know when a runaway gap will
   turn into an exhaustion gap. The volatility aspect makes it a very high-risk situation. It can,
   however, identify a strong trend.
4. Exhaustion gap: The last gap in a trending market that is eventually reversed. If the move
   leading into the exhaustion gap was very steep, then the ensuing correction can be expected
   to be very steep as well.

Island reversal tops consist of a market that has gapped higher (exhaustion gap), followed by one
or more days trading within a narrow trading range above the gap. Then prices gap down, leaving
those few days of trading looking like an island, surrounded by gaps. Figure 4.7 showed a one-day
island top. Island reversals (tops or bottoms) often indicate a significant trend reversal.

Question 48

What rules can be followed to prevent or minimize the potential losses that can be incurred due to false breakouts?

Answer 48

1. Chart analysis is often best used not in isolation but in conjunction with other indicators.
   For example:
   * Breakouts should be accompanied by higher volumes, and in the case of futures
   contracts, expanding open interest.
   * Traders should watch the broader picture and take into account the underlying longer
   term trend.
2. A higher level of confidence can be achieved when the trader waits for a breakout of at least
   a minimum percentage above the breakout point, and/or a minimum number of days have
   passed after the signal was received.
   Naturally, there is a trade-off. While a longer waiting period or more conservative price
   breakout will reduce false signals, it will also reduce potential profits. As traders become
   more experienced, they will develop an equilibrium between setting trading rules that are
   too restrictive and those that are not restrictive enough.
3. Even the best traders are typically wrong more than 50% of the time. What separates
   successful from less successful traders is their strict adherence to money management
   principles (covered in Chapter 14). One such principle is the use of stops. In the case of the
   head-and-shoulders formation, a closing stop should be placed slightly under the neckline.

Question 49

How do you draw the neckline for a head-and-shoulders formation?

Answer 49

A “neckline” is drawn by connecting the lowest points of the two troughs. The slope of this line can either be up or down. HS TOP SHOULD BE UPWARD SLOPING WHILE HS BOT SHOULD BE DOWNWARD SLOPING!

Question 50

At what point is a head-and-shoulders formation confirmed?

Answer 50

Final confirmation comes when volume further increases during the decline of the right shoulder. Neckline Break: The head and shoulders pattern is not complete and the uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincing manner, with an expansion in volume.

Question 51

What is a false breakout?

Answer 51

A false breakout is a significant movement out of a market’s normal support or resistance levels that doesn’t last – hence it ‘fails’ These can cause costly mistakes for traders thinking a market has hit a true breakout and to go long, only for it to lose momentum shortly afterwards.

Question 52

Why must we pay attention to volume when looking at price action?

Answer 52

Volume measures the number of shares traded in a stock or contracts traded in futures or options. Volume can indicate market strength, as rising markets on increasing volume are typically viewed as strong and healthy. When prices fall on increasing volume, the trend is gathering strength to the downside.

Question 53

What is a potential risk of conservative entry into a head-and-shoulders formation?

Answer 53

If the you are waiting for a retest of the neckline, it may not happen, and you might miss the trade.

Question 54

What is a potential risk of premature entry into a suspected formation pattern?

Answer 54

RISK OF FAILURE - A PATTERN IS NOT A PATTERN UNTIL IT IS COMPLETE!

Question 55

What is the difference between a red and green volume bar?

Answer 55

A red volume bar means that the stock closed lower during the current interval compared to the previous interval’s close. So, a tall green volume bar means an interval where the stock closed higher than the previous interval with high trading volumes – a sign of optimistic investor sentiment towards the said stock.

Question 56

TRUE or FALSE: The probability of correction to the neckline of a formation diminishes the more down sloping the neckline is (in the case of a BOTTOM formation).

Answer 56

TRUE!

Question 57

TRUE or FALSE: Increasing the timeframe increases the reliability of the trend.

Answer 57

TRUE!

Question 58

Is there a measured move for rounded tops and rounded bottoms?

Answer 58

NO!

Question 59

What is the role of volume in signalling trends and trend reversals?

Answer 59

Rising volume points to intensifying momentum and possible continuations of the trend, while declining volume suggests waning momentum and an increased likelihood of reversals. Specifically, volume analysis helps traders evaluate: Momentum and intensity behind trends.

Question 60

What is the method of determining the measured move for a double top and double bottom formation?

Answer 60

Take the longer distance of the two bottoms to the neckline and extend that same distance to a higher, future level in the market.

Question 61

Why are intraday highs and lows important?

Answer 61

Intraday highs and lows are important because they help traders assess market volatility, identify trends, and determine potential support and resistance levels within a trading day.

Question 62

What are upside and downside reversals?

Answer 62

An upside reversal indicates a potential shift from a downward to an upward trend, while a downside reversal suggests a shift from an upward to a downward trend.

Question 63

What percentage should you put a stop loss?

Answer 63

The percentage method involves setting a stop-loss level as a percentage of the purchase price. This method allows traders to adapt their risk management strategy based on the volatility of the stock. A common practice is to set the stop-loss level between 1% to 3% below the purchase price.

Question 64

What is a basing pattern?

Answer 64

The term basing refers to the consolidation in the price of a security. This movement in price is commonly used by technical analysts and usually comes after a downtrend before it begins a bullish phase.

Question 65

Describe the multiple head-and-shoulders formation.

Answer 65

One variation of the head-and-shoulders pattern is the multiple head and shoulders. The concept
is the same as the head and shoulders, except that both the left and right shoulders have multiple
peaks and troughs (see Figure 4.3). This pattern is not as reliable as the simple head and shoulders
and is more indicative of a consolidation pattern, although it can and does forecast trend
reversals. It is also very similar to a rounded top pattern. It can have multiple false breakouts and
can very often turn into a basing pattern.

Question 66

TRUE or FALSE: Rounded top and rounded bottom
patterns (also known as saucer tops or saucer bottoms) create very strong support and resistance
levels and typically take a long time to develop.

Answer 66

TRUE! - And remember; LENGTH OF PATTERN IS DIRECTLY RELATED TO ITS IMPORTANCE!

Question 67

Explain the general concept of gaps.

Answer 67

A gap is an open space on a chart where no trading occured. Gaps normally occur for one of
two reasons. They can be caused by the announcement of some unexpected information, such
as a company’s quarterly earnings released after the bell, which is either well above or well below
expectations. Gaps can also occur on charts due to overnight trading, especially in foreign
markets. Although this is being diminished by 24-hour trading platforms for many major types
of securities, a major earthquake in Japan for example, would cause the North American-listed
Japanese equities and ETFs to gap down. By the time North American markets open for trading,
prices are already either above the previous day’s high or below the previous day’s low, and stay
that way for the rest of the trading session, resulting in a price gap on the chart.

Question 68

Why are gaps significant?

Answer 68

Gaps in trading are significant because they represent a sudden shift in supply and demand. A gap occurs when the price jumps between two trading periods without any trades occurring in between, often in response to news or events. This can indicate strong buying or selling pressure and potentially signal the start of a new trend or a significant shift in market sentiment.

Question 69

What does “filling a gap” mean?

Answer 69

A stock gap is a large jump in a stock’s price after the market closes, usually due to some news. When a gap has been filled, this means the stock’s price has returned to its “normal” price; the pre-gap price. This happens quite often as the price settles after irrational buying and trading has stopped after the news.

Question 70

What happens when things move too far too fast?

Answer 70

A reversal is bound to happen.

Question 71

Are breakouts typically accompanied by high volume?

Answer 71

YES!

Question 72

What is the difference between green and red candlesticks?

Answer 72

Traditionally, bullish candlesticks are depicted in green or white, symbolizing upward price movements, while bearish candlesticks are portrayed in red or black, indicating a downward trend.

Question 73

When do most triangles breakout?

Answer 73

Most triangles breakout 2/3 to 3/4 of the way through a pattern.

Question 74

TRUE or FALSE: Ascending triangles are more predictable than symmetrical triangles.

Answer 74

TRUE!