This Weekend’s Trading Lesson From TradingMarkets

Editor’s Note:

 

How To Determine
Directional Strength With Short-term Patterns

By David Landry

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.

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.

 

Figure 1. Dec. ’99 gold (GCZ9), daily. Source: Quote.com.

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.

 

Figure 2. Dec. ’99 crude oil (CLZ9), daily. Source: Quote.com.

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.

 

Figure 3. Microsoft (MSFT), daily.

Spikes and Wide-Range Bars
Spikes are price bars that extend much higher or lower than surrounding price
bars. Like many gaps, they usually reflect extreme market sentiment and can be
followed by price reversals or consolidations. Again, where a spike occurs is
important. In a trading range, a spike may just be a temporary price shock; when
a spike occurs after an extended trend, it can be a sign of a price extreme, or
“blow-off,” that signals price exhaustion.

 

Figure 4. eBay (EBAY), daily.

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.

 

Figure 5. Geron (GERN), weekly.

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) A reversal high day is a
day that makes a new high and reverses to close below the previous day’s close
(or, in the bottom 25% of the day’s range). A reversal low day is a new low that
reverses to close above the previous day’s close (or, in the top 25% of the
day’s range). Such bars are common, and should not even be considered as
reversal days unless they occur in established uptrends or downtrends,
specifically.

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.

 

Figure 6. Yahoo (YHOO), daily.

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.

 

Figure 7. Yahoo (YHOO), daily.

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.

 

Figure 8. Globespan (GSPN), daily. Source: Quote.com.

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.

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.