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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Stock charts print many unique topping formations. Many can be understood and traded with very little effortREVERSALS Why does the descending triangle work with such deadly accuracy? Most swing traders really don’t understand how or why patterns predict outcomes. Some even believe these important tools rely on mysticism or convenient curve fitting. The simple truth is more powerful: congestion patterns reflect the impact of crowd psychology on price change. Shock and fear quickly follow the first reversal that marks the triangle’s major top. But many shareholders remain true believers and expect their profits will return after selling dissipates. They continue to hold their positions as hope slowly replaces better judgment. This initial selloff carries further than anticipated and their discomfort quickly increases. But just as pain begins to escalate, the correction suddenly ends and the stock firmly bounces. For many longs, this late buying and short covering reinforces a dangerous bias that they were right all along. Renewed confidence even prompts some to add new positions. But smarter players have a change of heart and view this new rally as their first chance to get out whole. They quietly exit and the strong bounce loses momentum. The stock once again rolls over and draws the second lower top of the evolving pattern. Those still holding long positions then watch the low of the first reversal with much apprehension. Prior countertrend lows draw scalpers and investors familiar with double bottom behavior. As price descends toward the emotional barrier of the last low, they step in and stop the decline. But the smart money stands aside and the subsequent bounce only draws in new investors with very bad timing. As the pattern draws its third peak, the last bullish energy dissipates from the criss-cross price swings. Price continues to hold up through this sideways action but relative strength indicators signal sharp negative divergence. Momentum indicators roll over and Bollinger Bands contract as price range narrows. The scalpers depart and this final bounce quickly fades. Shorts now smell blood and enter larger positions. Fear increases and stops build just under the double low shelf. Price returns for one final test as negative sentiment expands sharply. Price and volatility then contract right at the breaking point. The bulls must hold this line, but the odds have shifted firmly against them. Recognizing the imminent breakdown, swing traders use all upticks to enter new short sales and counter any weak bull response. Finally, the last positive sentiment dies and horizontal support fails. As the sell stops trigger, price spirals downward in a substantial decline. Stock charts print many unique topping formations. Many can be understood and traded with very little effort. But the emotional crowd also generates many undependable patterns as greed slowly evolves into mindless fear. Complex rising wedges will defy the technician’s best efforts at prediction, while the odd diamond formation will burn trading capital as it swings randomly back and forth. Avoid these fruitless positions and seek profit only where the odds strongly favor the predicted outcome. First locate the single feature common to most topping reversals: price draws at least one lower high within the broad congestion before violating the major uptrend. This simple double top mechanism becomes a primary focus for short sale planning. Use this well-marked signpost to follow price outward to its natural breaking point and enter when support fails. Flip over the Adam and Eve bottom pattern and find a highly predictive setup for topping reversals. This Adam and Eve top offers swing traders frequent high-profit short sales opportunities. Enter new shorts when price violates the reaction low, but use tight stops to avoid whipsaws and 2B reversals. These occur when sudden short covering rallies erupt right after the gunning of stops just below the failure. Each uptrend generates positive sentiment that the topping formation must overcome. Adam and Eve tops represent an efficient bar structure to accomplish this task. The violent reversal of Adam first awakens fear. Then the slow dome of Eve absorbs the remaining bull impulse while dissipating the volatility needed to resume a rally. As the dome completes, price moves swiftly to lower levels without substantial resistance. Observant swing traders recognize the mechanics of descending triangles and Adam and Eve formations in more complex reversals. The vast majority of tops display characteristics of these two familiar patterns. Crowd enthusiasm must be eliminated for a decline to proceed. Buying interest eventually recedes through the repeated failure of price to achieve new highs. Then the market can finally drop from its own weight. Price draws a double top when it can’t pass the resistance of the last high. The more violent the reversal at the initial top, the more likely the first attempt to exceed it will fail. The longer it takes for this test to approach the first top, the more likely it will fail. When both conditions support a double top failure, swing traders can sell short into the second rise if: • They are willing to exit immediately if price violates the old high. • The execution target stands at or just below the old high. The third rise into a top should rarely be sold short. Markets can easily head to new highs when they turn and rally after pulling back from a first failed test. This first attempt washes out shorts and those that missed selling on the initial top. The third rise allows accumulation to build and sets up a classic cup and handle breakout pattern. It also traps shorts from the failed test and uses their buying power to build a new uptrend. DECLINES The same crowd that lifts price provides the fuel for a subsequent decline. Longs build false confidence after rally momentum fades and a topping pattern forms. As smart money quietly exits, the uptrend hits a critical trigger point: the bulls suddenly realize that they are trapped. They start to dump the stock in an attempt to salvage profits. Price breaks support and selling spirals downward through wave after wave. Common features appear in most price declines. Volume repeatedly surges through waves of selling pressure while false bottoms print and then quickly fail. Violent covering rallies erupt to shake out poorly timed short sales and offer hope to wounded longs. Price carries well past rational targets, but just as panic builds, the stock finds a sustainable bottom. The swing trader capitalizes upon this repeating market behavior through the same wave mechanics that guide strong rallies. But fear replaces greed during sell- offs and invokes different setup considerations. When R. N. Elliott discussed primary trend waves in the 1930s, he noted the special characteristics of downtrends through the five-wave decline (5WD) pattern. This price correction structure remains as effective today as it was many decades ago. And swing traders can apply its power without understanding the broad Elliott Wave Theory, because it captures the fear of the emotional herd. The 5WD consists of three primary trend impulses and two reactions, just like its uptrend cousin. Direct waves push lower in this complex pattern between countertrend bear rallies. The middle wave often prints a downtrend continuation gap as dynamic as the uptrend version. The last impulse can reflect parabolic movement driven by intense fear. After this drop, the uptrend may resume immediately. But more often price forms a double bottom or similar pattern that provides a good base for a breakout above the downtrend line. The first impulse (TOP) corrects the uptrend that carries an issue to a new high. This often prints a first failure retracement. It also initiates the price decline that completes the stock’s technical breakdown through the third wave (1). Volume peaks sharply during this middle correction as shareholders recognize the ugly event. But the worst is usually reserved for last in major declines. As the third wave completes, a false bottom paints a comforting picture that slows the selling and brings in new value longs. The decline then suddenly resumes and accelerates into an emotional fifth wave (2) that violates popular targets and reasonable support zones. Note that the top of the fourth wave can reach up and touch the bottom of the second wave during the 5WD. This would violate common EWT rules if it occurred during a rally instead of a selloff. The fifth wave panic extinguishes the selling pressure and bounces the stock. This rapid upward motion squeezes shorts and ignites the first impulse of a possible new uptrend. The strong rally then quickly fails. As longs brace for more pain, the prior low unexpectedly holds. A new crowd notices the support and steps in. Price builds back to the 1-2 trendline as a double bottom forms. The balance of power then shifts and the stock breaks out through that line into a new uptrend. Orient the decline against broader uptrend movement to predict price evolution. Start with Fibonacci retracement analysis and measure the selloff against the prior trends. One simple 5WD structure draws the first wave to 38%, the second to 50%, and the final impulse to 62% of a larger uptrend. This predicts that price will eventually return to test the high where the decline originally began. But if the pattern corrects 100% or more of a major rally, the subsequent bounce could be very weak and the stock may eventually go lower. Expect price to break through the down trendline in these conditions but quickly pause and drop back below new support. Trade defensively and capitalize on the price swings. Then shift tactics quickly when the bottom appears ready to break. 5WD short selling requires great precision. The 1-2 trendline consists of only two points unless the TOP aligns perfectly with the next two impulses. So this important signpost doesn’t really print until the second major selloff breaks to new lows. The first upward impulse after the climax marks a good short entry if price gets close enough to the trendline. But this setup carries a lower reward than the other downward moves and the position requires countertrend entry because price should eventually hold above the prior low. The best short sales arise from natural breakdown points as impulses violate prior support. Avoid positions on the first impulse since this wave may complete with no technical breakdown. This first decline also faces a short squeeze danger and a large pool of potential longs. The second downward 5WD impulse (1) may begin close to the high of the TOP. This forms a classic double top pattern. Subsequent waves present less danger to short positions as the bear mentality undermines price recovery. Locate logical entry points where weak rallies bounce into major resistance. Experience teaches that downtrends do not easily give way to new uptrends. While a break of the 12 trendline marks the completion of the 5WD, subsequent price movement may not generate much momentum. Try to capture the expansion move across the trendline or the first pullback for a quick swing trade. Then exercise caution to see how the new uptrend develops. Remember the old adage: the bigger the move, the broader the base. Long declines need time to heal and the broken trendline may only yield to a sideways market. Price break momentum will be directly proportional to the distribution level during the previous decline. Recognize those times when price will likely rise at the same angle at which it originally fell, and watch out for those times when it won’t. The skilled eye will find 5WDs in all time frames. Some exhibit sharp vertical selloffs, while others move sideways and provoke far less attention. Both occurrences allow swing traders to focus attention on price correction and find low-risk entry on both sides of the market. Fit this volatile formation into its proper stage within the broad Pattern Cycles structure. Then watch how markets create opportunity through the evolution of the master pattern. |
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