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One of the more reliable 1-2-3 patterns is a “W” bottom. It is also known as a double bottom with a higher right side breakout; and, of course, it is similarly dubbed a 1-2-3 swing bottom formation, as shown in Figure 4.10. The opposite is what we call an “M” top, or double-top pattern, as illustrated in Figure 4.11.
You want to be sensitive to these chart patterns due to the higher frequency of occurrences. Not all “W” bottoms have the same type of reaction and come disguised as rounding bottoms or the cup-and-handle pattern. Let's examine Figure 4.12. As you can clearly see, the 1-2-3 formation was confirmed once the market closed above the first high, or point 2. Once that occurs, look for a two-period close to confirm that prices have adjusted to test a new range expansion. Fibonacci techniques can be introduced in helping to identify point 3. We will generally see a 0.50 percent but more than likely a 0.618 percent retracement from the low of point 1 to the high of point 2. The Canadian dollar chart shown in Figure 4.12 is a five-minute chart. We see that prices did trade back as point 3 formed, but never did the price violate or close below the 0.618 percent retracement level. This mar ket broke out once confirmed by the two-period close, which it added on a 48-PIP (percentage in points) gain in less than 50 minutes.
Falling Wedge Patterns
A falling wedge pattern is simply a long-term price pattern that resembles a downward sloping triangle formation, as Figure 4.13 shows. The mea surement from the distance of the wedge “opening” to the point of the breakout that occurs near the apex gives the extension or measuring dis tance used to determine a price objective.
Watch for the first dip or retest of the trend-line resistance line once the breakout is confirmed. This action usually has prices responding like bouncing off a springboard. Remember the two-period close rule: If prices start accepting the new trading zone outside the wedge formation by more than two periods, odds increase for prices to press or test a new high terri tory. That's not to say that they want to wash you out of the game by retracing and retesting the point of breakout. Once again, that point is the upward resistance line. The 30-minute chart on the Japanese yen versus the U.S. dollar in Figure 4.14 helps highlight the sequence of the breakout and retracement job right before the violent and explosive short covering move takes place.
Rising Wedge Patterns
Rising wedge patterns are narrowing peaks, as Figure 4.15 illustrates. We can generally see these show up on our radar screens when using moving average convergence/divergence (MACD) or stochastics as they form bearish divergence patterns. We see this formation at the fifth extension wave, which is the end of an Elliott wave cycle. The markets hardly ever reward the masses; and when we see this pattern form, the natural tendency is for traders to overlook the negative implications and only see that prices are making new highs.
Be warned, because after a prolonged uptrend, the narrowing effect of each price range that completes the rising wedge gives a clue that prices are ready to reverse. Keep in mind that after a prolonged uptrend, bulls may be overextending their welcome in the trade. A classic example is shown in Figure 4.16, as descending triangle patterns form as prices plummet. You should watch for these narrowing patterns, and keep in mind that the markets can retest the breakdown support line before resuming the descent, as shown in the Canadian dollar chart.
Sideways Trend Channels
A sideways trend channel is a type of flag formation. There is not much to explain on how to identify a channel; the market bounces between two par allel trend lines between highs and lows, namely, the support and the re sistance trend lines. Figure 4.17 shows it best.
There is a trick, and that is to successfully identify the support or re sistance lines early in the channel's development. Once they are established, traders can go long or buy near the support line or sell short or liquidate longs near resistance lines. The element of risk exists when the market finally breaks out from this channel, or band. Chartists can trade another method of these so-called bands by buying once the market breaks out above the resistance line, as confirmed by two consecutive closes above the resistance line, or by taking a short position once the market breaks below the support line, as confirmed by two consecutive lower closes below the support level. Forex traders will see countless opportunities to trade these patterns because they form frequently. One rule of thumb is that the longer the channel, the bigger the breakout. Also watch out for the false breaks. There are many instances where an equal-and opposite candle pattern will form, thus tricking traders into losing posi tions. Since sideways channels indicate indecision or a pause, it is only natural for dojis to appear with these ranges. Therefore, I like to watch for shifts in the momentum by trying to spot a high close or a low close doji. Figure 4.18 shows a great example of a low close doji signal within the sideways channel. Treat this setup as you would an LCD pattern. That involves selling on the close of the candle that closes below the doji low or the next time frame's open.
Head and Shoulders
Head and shoulders patterns are types of “M” tops. The head and shoul ders top or inverted head and shoulders bottom can be used not only as a directional price-indicating pattern but also as a measuring or price projecting indicator.
A textbook topping pattern is illustrated in Figure 4.19 as the head and shoulders top formation. Head and shoulders tops or bottoms are considered to be strong indicators of major trend reversals. There are four com ponents involved with the head and shoulders pattern: (1) The left shoulder is formed. (2) A higher high occurs forming the head. (3) The development of the right shoulder is formed. (4) The so-called neckline is formed. The symmetry or distance is important. The distance from the left shoulder to the head should be about the same as the distance from the right shoulder to the head. If you measure the distance from the bottom of the head to the neckline, that will give you the next price target level. In other words, by measuring from the bottom of the head to the bottom of the neckline in a head and shoulders top formation, you will be able to project approxi mately where prices may go. Figure 4.20 shows a perfectly conceived head and shoulders top pattern. If you are looking for a trade based off this formation, keep in mind that this type of pattern is easily recognized by the masses and, therefore, sometimes does not work. If you sell short, look for a two-period close below the neckline, and make sure the price action does not rally back and take out the high of the right shoulder.
The opposite is true for an inverted head and shoulders bottom formation. If this pattern works, it is great; but you need to be aware of the traps associated with certain patterns, and the failed neckline breakout is a common one. I again stress that you would like to see a two-period close above the neckline in an inverted head and shoulders bottom to confirm that prices indeed have reversed and that the momentum is now positive. The two-period close negates the equal-and-opposite reversal formation as well (see Figure 4.21).
Cup and Handle Pattern
The cup and handle pattern is a bullish continuation pattern that is formed with a saucer or rounded bottom and then breaks out only to correct back down before resuming a continuation of the uptrend. It is a type of “W” bot tom. William O'Neil is credited with introducing this pattern in his book, How to Make Money in Stocks (McGraw-Hill, 1988). Figure 4.22 shows the making of this pattern; there is a high frequency of this variation that occurs in the forex market since the concept is based on the premise that it forms in a bullish accumulation period. As its name implies, there are two parts to the pattern: the cup and the handle. The cup forms after a decline; and as prices consolidate, the market forms the rounded bottom. As the cup for mation completes, a small trading range develops on the right-hand side, and the handle is formed. A breakout from the handle's trading range sig nals a continuation of the prior advance.
Ideally, the depth of the cup should retrace 0.38 percent or less of the previous advance. The handle forms after the high is established from the first rally made on the right side of the cup. Many times the handle resembles a flag or a pennant formation. The handle represents the final consoli dation phase before prices go into hyperrally mode. The correction can retrace by 0.38 percent of the cup's advance, but usually not more. The smaller the retracement is, the more bullish the formation and the more sig nificant the breakout.
As with most chart patterns, it is more important to capture the con cept of the pattern than every detail; and the one concept with which you should familiarize yourself is a consolidating rounded double bottom. The cup is a saucer-shape consolidation, and the handle is a short pullback fol lowed by a breakout. The measuring technique to determine the minimum upside price objective for a cup and handle pattern is figured by adding the height of the cup or saucer bottom to the breakout point from the handle.
Figure 4.23 shows a classic cup and handle pattern as it forms at the pivot point support target in the euro currency based on a five-minute time period. This is the essence of an accumulation period. It tires and bores traders; and as the handle forms, it scare traders into exiting longs or, even worse, going short at support. It is this period of consolidation that creates indecision. Once prices take off, it causes shorts to run like mad for cover.
The chart patterns covered here integrate with candle charts and all aspects of technical analysis that we will be covering in the next few chapters. As a discretionary trader, once you understand how these patterns form, the psychology behind the consolidation phases will give you the con fidence needed to conquer the forex market.
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