How To Determine Directional Strength With Short-term Patterns
Short-Term Chart Patterns
In Basic Chart Analysis: Trends, Trading Ranges, and Support and Resistance and Chart Classics: Reversal And Continuation Patterns, we discussed the fundamental principles of chart analysis and the trading implications of many of the better-known chart patterns. While most of these consist of five or more bars, many chart “patterns” contain only one to three bars and are of special interest to traders since they are associated with short-term price extremes.
Gaps, spikes, wide-range days, and reversal days and are some of the more popular examples of this group. Like their longer-term cousins, these patterns are subject to a great deal of misinterpretation–which can be eliminated by remembering a few simple rules. We’ll explain these patterns and show you how to make sense of them.
One-day wonders
Gaps
A gap occurs when today’s low is higher than yesterday’s high or today’s high is lower than yesterday’s low, forming an open (vertical) space between bars. An opening gap refers to an opening price that falls outside the range of the previous day’s bar.Gaps are quite common, and are often no more than relatively meaningless reactions to news events (or rumors); these can be exaggerated in thinly traded or highly volatile markets. For the most part, gaps that occur in choppy or trading range markets are less significant than those that occur when markets embark on a new price move or during an accelerated phase of a price move (e.g., a “parabolic” rally or decline).
When markets are moving with great force, they will often gap from one day to the next. So, on one hand, gaps can be evidence of a strong trend or runaway move (the reason gaps in these situations are called “runaway” gaps). On the other hand, gaps can be evidence of price exhaustion at the end of a trend, and can present opportunities to take positions in the opposite direction of the gap (“fading” the gap).
Similarly, opening gaps sometimes present opportunities to trade counter to the direction of the gap after the initial selling or buying “panic” subsides and the market reverses. There are many reasons this can happen–the release of an early morning economic report, or an earnings announcement the previous evening; for some examples, see Kevin Haggerty’s article on
Opening Reversals and the definition of his
Trap Door trade.
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| Figure 1. Dec. ’99 gold (GCZ9), daily. Source: Quote.com.
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Figure 1 shows several gaps, some of which underscore the most accelerated portion of this year’s rally in gold. Notice also the gaps that punctuated the initial upside move out of the very narrow trading range (red) and the larger one that encompassed it (blue). Such gaps are sometimes called “breakaway” gaps because they sometimes kick off forceful price breakouts.
Beware of the old maxim “gaps are meant to be filled.” While many gaps are indeed filled within a few days of forming (forming convenient price targets for traders looking to fade the gap move), charts are rife with gaps that have never been filled, or that were filled so long after forming they might as well not have been. However, because very large gaps, or successive gaps often accompany extreme price moves, any trader looking for pullbacks would do well to monitor such moves closely.
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| Figure 2. Dec. ’99 crude oil (CLZ9), daily. Source: Quote.com.
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Figure 2 shows a number gaps in the crude oil market. Notice that most of these gaps were filled or reversed relatively quickly (by other gaps in some instances). Island reversals are a specific pattern in which a market gaps up to a new high or low bar (or to two or three higher or lower bars), then gaps back in the opposite direction.
There are two things to be aware of here. First, the initial gap suggests the market could accelerate in the direction of the gap. But the failure to follow through and the gap in the opposite direction implies a last-gasp exhaustion move; the move through the level of the initial gap negates the original price move and offers a logical entry point. Figure 3 shows an example of a one-bar island bottom.
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| Figure 3. Microsoft (MSFT), daily.
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Spikes
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| Figure 4. eBay (EBAY), daily.
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The spike high shown in Figure 4 capped off an uptrend on a weekly chart and turned out to be a fairly significant reversal point. To confirm such signals, it is advisable to wait for price to move convincingly in the desired direction–back below the low of the spike bar (at a minimum), in this case. By comparison, Figure 5 shows a few spikes that, in retrospect, were anomalous interruptions to an ongoing trading range.
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| Figure 5. Geron (GERN), weekly.
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Obviously, there’s a little 20-20 hindsight involved here. A “spike” up that was followed by subsequent up bars would simply be a wide-range bar (also called large-range bars), which is a bar with a significantly larger range than preceding bars. (How many bars, and how much bigger a bar must be to qualify as a wide-range bar can be defined mathematically–for example, two or three times the average bar of the last n days–but for now we’re just talking about the basic principle.) Conversely, you could argue that a wide-range bar followed by a number of bars in the opposite direction becomes a spike.
As you may have guessed from the discussion (and the chart examples) so far, the kinds of patterns we are describing here frequently are associated with short-term volatility extremes; markets will often pause after such moves, even if they resume in the same direction. For a more detailed look at this characteristic, read our article in the Advanced Traders Strategies section that shows the result of a two-year study of wide-range bars in the T-bond market.
Reversal days (or “key” reversal days)
The basic message here is clear, though: Price is making a new high (or low) and then abruptly reverses, closing strongly in the opposite direction. Such action can accompany a sentiment shift or reflect trend exhaustion. The question is, can you do anything with this information?
Not very easily, without some modification to the basic pattern. In fact, studies have shown that reversal days are particularly misleading and ineffective trade signals. The reason: The pattern’s standard requirements are not stringent enough to identify the more extreme price action that would typically accompany a swing point or reversal point.
Take a look at Figure 6. Reversal high days are marked with red dots, reversal low days with blue. Before getting too excited by the signals that occurred at some of the major tops and bottoms, notice how many other days had similar signals. Obviously, these basic signals, by themselves, are dangerous trading guideposts.
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| Figure 6. Yahoo (YHOO), daily.
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Making the requirements for a reversal day more strict can help eliminate many of the superfluous signals. Figure 7 shows the same chart, with one slight modification: Instead of a close above/below the previous day’s close, the reversal day must close above/below the previous day’s low/high. This eliminates many of the good signals, but eliminates many more of the bad signals. Other rules that would help isolate more likely swing or reversal points would be to require that a reversal day be the highest high or lowest low of the past n days, or that the reversal day high or low exceed the previous high or low by a specific amount.
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| Figure 7. Yahoo (YHOO), daily. |
Keep things in perspective
Even more so than many longer-term patterns, short-term patterns must be placed in context to provide any useful trading information. The larger environment in which a pattern occurs will determine whether or not it presents a useful trade opportunity or a questionable gamble.
Consult a longer-term chart to know what your market is doing from a macro perspective. Is that up gap on the intra-day chart really a good buy signal? Perhaps not, if the market has been trading lower on the daily chart and the move stalled and suddenly reversed at a conspicuous resistance level. One of the most important things to keep in mind is that in non-trending markets, many short-term patterns are just noise. It is in trending or breakout situations that these patterns can alert you to potential price acceleration or exhaustion
Another thing to keep in mind is that these patterns (like others) reinforce each other. For example, a spike day that also fulfills the requirement for a reversal day is more likely to be followed by a reversal than either pattern on its own: Price has make an extreme blow-off move and has reversed dramatically intra-day.
In Figure 8, a breakaway gap is followed two days later by back-to-back wide-range bars (the second of which will turn out to be a spike top)–signs of an extremely accelerated move susceptible to reversal or partial retracement. In fact, a third wide-range bar down suggested the up thrust was a blow-off move. Then, as discussed earlier, this high volatility move was followed by a consolidation before the market continued moving down.
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| Figure 8. Globespan (GSPN), daily. Source: Quote.com.
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This example also highlights another important point. Like other chart formations, the price action implied by the pattern is negated when price reverse through it in the opposite direction. The two light-blue horizontal lines mark the bottom of the two wide range bars, either have which offered potential short entry points as the market moved through them on the downside.
A fundamental question
While pure technicians eschew any fundamental inputs in their analysis, deeming them meaningless at worst and redundant at best, knowing what’s happening outside the chart also goes a long way toward a practical interpretation of short-term chart patterns, especially intra-day. Knowing that a spike or wide-range is the result of a sketchy rumor, for example, will prevent you from taking what, on the chart at least, looks like a clear technical buy signal.
Gaps, wide-range bars and spikes are patterns that typically represent extreme price movement and volatility–emotional highs and lows in a market. As such, they are often followed by pauses or reversals. However, in the early phase of moves (especially after trading range breakouts, for example) they represent strong momentum. “Fading” such patterns should be done with caution. (Remember, not all gaps were meant to be filled…) After extended moves, these patterns can signal potential reversal or swing points, especially when many of several of these patterns come together at the same time.
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