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Let's Talk Patterns

It just so happens that just about all of the most common Classical TA Chart Patterns are present, at least once, somewhere in the last 15 years or so of Dow Jones Industrials' weekly price action. Hence, I have an almost perfectly simplified and consolidated, real life, context from which to present you the basics on price pattern recognition - and we also reap the real time benefits that come from knowing and understanding the influence that old patterns still have on current price action. A pattern from 15 years ago that serves as a great example may seem to be irrelevant to current price action, but that's not entirely true, and you'll see how those patterns, once having appeared, are always and forever present thereafter on the charts and continue to exert their influence on price long after their original effects. Two birds with one stone here as we study patterns and bring everything forward into current context as well!


Larger Image

Starting on the left and working to the right, we begin with the Flag pattern. One of the simplest phrases summing up just about everything I think we need to know about the Flag is the following: "The flag flies at half mast". It's a compressed horizontal consolidation pattern that looks like a flag (hence the name) whose measurement calculation is for a breakout that runs a distance more or less equal to the length of travel coming into the pattern. Those are very nice examples back in the late 90's on the Dow.

Next we run into a short term Double Top that created the upper limits for the Left Shoulder Neckline of the following intermediate term pattern, an Inverted Head and Shoulders Pattern whose Head is comprised of another "double" pattern, namely the Double Bottom. The double top and double bottom are easily recognized and intuitively understood - note how often they appear over the years on this time frame - and have breakout to target calculations that are roughly equal to the distance from their necklines to highs or lows, respectively (the Double Top Neckline is the low separating the two highs, and the Double Bottom Neckline is the high separating the two lows). The Right Shoulder of the IH&S is the consolidation zone (perhaps an ascending triangle on a smaller time frame) just under the IH&S Neckline drawn in blue. Traditional targeting techniques double the average shoulder low to neckline distance, or simply use an equal distance from head to neckline rule. Looks like that IH&S went to target. ;-)

At the end of the bull run up into the IH&S target, price entered into a Rising Wedge and then eventually broke down and retraced the entire wedge structure, completing target expectations there and also setting a floor in the process for a 2 year Rectangular Trading Range that also eventually ended up breaking down. This particular case is a very good example of how pattern recognition is not black and white though. I used that "trading range" as one of the fundamental building blocks for my Major Support Zone that I shared with you in my article Let's Talk Levels, but from a pattern standpoint, I've chosen to label it as a Symmetrical Triangle Top (a Rounding Top could also be argued). At first glance, the Symmetrical Triangle option looks to be the least accurate, but, with the help of a variation of the same chart above, I'll quickly show you how, in my opinion, it is actually the MOST accurate.


Larger Image

I have modified NO lines drawn on that chart. Everything is exactly the same except for the price data which is now reflected as weekly closing data on a line chart. What is impressive is how clear the Symmetrical Triangle now becomes. Complete with two head fakes (on a closing basis that is - on an intra-week basis there were more, prior, outlying extremes). The apex ended up playing an important role in future significant support and resistance levels (combined with posterior price action of course) that continues to this day. Traditional break point to price target calculations equal the distance of the widest part of the triangle.

Moving on then to the next pattern, the Triple Bottom put in between 2002 and 2003, we see a nicely defined neckline that gave us a target right at the 10,700 area that was hit in less than a year's time (using the same traditional price target calculations as those used for double bottoms) and marked exactly where the next pattern, an Ascending Triangle began taking shape. Like the symmetrical triangle we dealt with earlier, this particular ascending triangle was not all that obvious either, especially when taking into consideration the 4 alternating touch rule for triangles. The dashed lines give us an "estimated ideal fit" and puts the apex right where final backtesting completed before the final intermediate run up into highs. The solid lines give us 4, clear, alternating contact points, with a breakout and subsequent throw back, that works well to satisfy the purists. In this case, I go with a wide boundary structure incorporating both lines. The first breakout before the throwback met minimum targets, and the second went well beyond maximum targets (as can always happen since targets are just rough ideas as to where price might go).

Then we run into a succession of 4 Head and Shoulders Patterns (all further reinforced by double topping or bottoming structures), the 2nd being an inverse head and shoulders, the 3rd failing to meet with expectations by breaking up instead of down, the 4th going to target, and all delimiting extremely important extremes. A side note here would be to mention the changes in necklines on the candlestick and line charts - the breakdown levels change little, but the backtest to neckline on the 2007-2008 top on the line chart might have had you thinking that the breakdown had failed, and the 2010 "breakdown" might have served as a bigger "trap". All things considered, I like to error on the side of including price extremes rather than not, and I use a closing basis line chart mainly as a confirmatory tool.

The last head and shoulders marked the beginning of a Rising Wedge. Wedges, while being a variant of the triangle, are different from the triangle in that they need 5 alternating touch points with price instead of just 4. The 5th touch in this case was also a slight overthrow, which is allowable and was confirmed as such once price headed south and took out the lower boundary. Price DID NOT continue lower after the lower boundary breakdown however. After a bit of a struggle, price managed to regain that lower boundary trendlines and move higher once again. My opinion is that this has created yet another, more powerful, secondary overthrow, and that the pattern is therefore still 100% active. Back in January of this year, Greg Schnell did a nice video covering 80 years' worth of major rising wedges on the SPX and one very important conclusion he came to was the fact that the key "line in the sand" in every case, was the extension of the lower rising trendline of the original rising wedge, and that once the lower rising trendline marking the original lower boundary of the rising wedge broke, it was game over. http://media.mta.org/videos/2013/educational-web-series/greg-schnell/greg-schnell.html

That almost brings this most common price pattern presentation - courtesy of the Dow - up to date, but we still haven't finished until we take couple of steps back and look at things from even further away, focusing on the two fat red lines forming the multi-year Broadening Pattern. We also need to tie in the rising wedge overthrow that has gone a long ways towards reaching the upper limits of that broadening pattern and remember that price just might insist on a direct hit. And we still haven't finished yet until we also take a close look at how the patterns helped define, and now confirm much of, the horizontal S/R that I outlined in Let's Talk Levels. A huge horizontal range was built between 7500 and 11,000, with two major excursions above, between 2005 and 2008 and 2010 to present. The range is well constructed with strong price pattern support and resistance reflecting the tremendous bull-bear battles that have taken place there.

Price could just as well complete up to the upper limits of the major Broadening Pattern, as it could fail, but, either way, up first and then down, or just down, the next big multi-year task at hand in my opinion should be some sort of "backtest" of the breakout from the huge 7500-11,000 range. Broadening patterns can fall all the way back to their lower boundaries, but partial declines (halfway down for example) are not uncommon. Either way, that's a long ways to fall, and while that may seem a little far fetched to us right now, when combined with a rising wedge's traditional target of a complete retracement of its entire structure, maybe it's not so far fetched after all. Do you think Mr. Market might want to validate 11,000? ;-)

A couple a final notes to end on: 1) it's always good to compare with other, similar indices, and with that in mind I leave you with a couple of line charts with comparable patterns on the SPX and the NYA; 2) given that my objective is to present these basic TA tenets in a comprehensive, yet as uncomplicated manner as possible, I've left a lot out, as always, and for those who want to delve deeper and go beyond the likes of "traditional calculations", for example, The Pattern Site is a great place when it comes to patterns, and with that also in mind, I leave you with a modified version (candlesticks stripped out - that's for another day) of their Common Chart Patterns table just below the two charts.

$SPX S&P 500 Large Cap Index INDX

$NYA NYSE Composite Index INDX

 

Upward Breakouts

 

Downward Breakouts

Chart Pattern

 

Chart Pattern

Broadening bottom

 

Broadening top

Cup with handle

 

Double bottom, Eve and Eve

 

Double top, Eve and Eve

Flag, high and tight

 

Head-and-shoulders bottom

 

Head-and-shoulders top

Triangle, ascending

 

Triangle, ascending

Triangle, descending

 

Triangle, descending

Triangle, symmetrical

 

Triangle, symmetrical

Triple bottom

 

Triple top

 


The original table with Candlestick patterns can be found here: http://www.thepatternsite.com/CandleCPBkout.html#NOB4

 

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