by John Lansing | October 25, 2012 1:45 pm
Technical analysis is the most accurate way to predict when a stock is going up. It’s also the best way to tell when a stock is headed for a fall.
And knowing when a stock is likely to head south is a vital skill for any trader, because it can help you to get your money out before you lose it or, even better, play the downside action with put options.
So I’m going to teach you about some bearish chart patterns that indicate a stock is heading down. If you learn how to spot these patterns, you can reduce your loses and increase your profit-making potential.
A double-top is a reversal pattern that occurs when prices are in an uptrend. Sometimes called an “M formation” because of its shape, the double-top is one of the most common chart patterns. Because they seem to be so easy to identify, though, traders need to be careful.
A double-top consists of two well-defined, sharp peaks at approximately the same price level. Prices rise to a resistance level, retreat, and return to the resistance level again before declining. A double-top often forms in active markets that are experiencing heavy trading. A stock’s price heads up rapidly on high volume. Demand falls off and the price falls, often remaining in a trough for weeks or months.
An important note: A double-top is only complete when prices decline below the lowest low — the confirmation point — of the pattern.
The head-and-shoulders top is an extremely popular pattern among investors because it’s one of the most reliable of all formations. It also appears to be an easy one to spot, and novice investors often make the mistake of seeing it everywhere. Seasoned technical analysts will tell you that it is tough to spot the real occurrences.
The classic pattern has three sharp high points, created by three successive rallies in the price of the financial instrument. The first point (the left shoulder) occurs as the price of the financial instrument 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 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 the low price point at the end of the left shoulder and the beginning of the uptrend to the head, and the low point 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. The pattern is complete when the support provided by the neckline is broken. This occurs when the price of the financial instrument, 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.
A triple-top is considered a variation of the head-and-houlders 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, where the head-and-shoulders top displays a higher peak — the “head” — between the two shoulders.
In a triple-top, 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 (the confirmation point) in the formation.
A bearish symmetrical continuation triangle shows two converging trendlines, the lower one is ascending, the upper one is descending. The formation occurs because prices are reaching both lower highs and higher lows. The pattern will display two highs touching the upper (descending) trendline and two lows touching the lower (ascending) trendline.
This pattern is confirmed when the price breaks out of the triangle formation to close below the lower (ascending) trendline. Volume is an important factor to consider.
Typically, volume follows a reliable pattern. Volume should diminish as the price swings back and forth between an increasingly narrow range of highs and lows. However, when the breakout occurs, there should be a noticeable increase in volume. If this volume picture is not clear, investors should be cautious about decisions based on this triangle.
A megaphone top, or broadening top, is a relatively rare formation. As a reverse symmetrical triangle, its shape is opposite to that of the bullish symmetrical triangle. The pattern develops after a strong advance in a stock price and can last several weeks or even a few months.
A megaphone top is formed because the stock makes a series of higher highs and lower lows, and usually consists of three ascending peaks and two descending troughs. The signal that the pattern is complete occurs when prices fall below the lower low.
Volume in the megaphone top usually peaks along with prices. It is usual to see trading volumes increase or remain high during the formation of this pattern. The eventual breakout and reversal can be difficult to identify at the time of its occurrence because volume does not appear unusual.
Diamond patterns usually form over several months in very active markets, and volume remains high during the formation of this pattern. The diamond top pattern occurs because prices create haigher highs and lower lows in a broadening pattern until prices break downward out of the diamond formation.
With a diamond top, you need to consider the duration of the pattern and its relationship to your trading time horizons. The longer the pattern, the longer it will take for the price to move to its target. The shorter the pattern, the sooner the price move. If you are considering a short-term trading opportunity, look for a pattern with a short duration. If you are considering a longer-term trading opportunity, look for a pattern with a longer duration.
The inbound trend is an important characteristic of the pattern. A shallow inbound trend may indicate a period of consolidation before the price move indicated by the pattern begins. Look for an inbound trend that is longer than the duration of the pattern. A good rule of thumb is that the inbound trend should be at least two times the duration of the pattern.
A bearish flag follows a steep, or nearly vertical decline in price, and indicates a current downtrend may continue. The pattern consists of two parallel trendlines that form a rectangular flag shape. The flag can be horizontal, however, it often has a slight upward trend.
The vertical downtrend that precedes a flag may occur because of buyers’ reactions to an unfavorable company announcement, such as a court case, or a sudden and unexpected departure of a CEO. The sharp price decrease is sometimes referred to as the “flagpole” or “mast.”
The rectangular flag shape is the product of what technical analysts refer to as consolidation. Consolidation occurs when the price seems to bounce between an upper and lower price limit. This pattern formation reflects the reaction of sellers who are willing to sell at a lower cost, and the influx of buyers who inadvertently drive up the price as they compete to buy at the best possible price.
A bearish signal occurs when the price rebounds beyond the lower trendline of the flag formation, and continues the original downward price movement. This is considered a pattern confirmation.
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