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TradingDay.com > Technical Analysis Tutorial

T e c h n i c a l   A n a l y s i s   T u t o r i a l
by Alan Farley

Pattern Cycles: Breakouts

Significant declines evolve into long bottoms characterized by failed rallies and retesting of prior lows. As new accumulation slowly shakes out the last crowd of losers, a stock's character changes. Prices push toward the top of key resistance. Short-term relative strength improves and the chart exhibits a series of bullish price bars with closing ticks near their highs. Finally the issue begins a steady march through the wall marked with past failures.

Stocks must overcome gravity to enter new uptrends. Value players build bases but can't supply the critical force needed to fuel rallies. Fortunately, the momentum crowd arrives just in time to fill this chore. As a stock slowly rises above resistance, greed rings a loud bell and these growth players jump in all at the same time.

The appearance of a sharp breakout gap has tremendous buy power. But the skilled trader should remain cautious when the move lacks heavy volume. Bursts of enthusiastic buying must draw wide attention that ignites further price expansion. When strong volume fails to appear, the gap may fill quickly and trap the emotional longs. Non-gapping, high volume surges provide a comfortable price floor similar to gaps. But support can be less dependable, forcing a stock to swing into a new range rather than rise quickly.

Fortunately this scenario sets up good pullback trades. The uptrend terrain faces predictable obstacles marked by Clear Air pockets and congestion from prior downtrends. These barriers can force frequent dips that mark good buying opportunities. The trader must identify these profitable zones in advance and be ready to act.

Gap breakouts are more likely to rise toward higher prices immediately than simple volume breakouts. Waiting for a dip may be futile. Extreme crowd enthusiasm ignites continued buying at higher levels and market makers don't need pullbacks to generate volume. If entry is desired, use a trend-following strategy and manage risk with absolute price or percentage stop loss.

As trend builds momentum, surges register on technical indicators such as MACD and ADX. Volatility absorbs each thrust and parabolic rallies erupt. Dips will cease during these runaway expansion moves as price range expands bar to bar, often culminating in a second (continuation) gap and a final exhaustion spike.

After rapid price movement, markets need time to absorb instability generated by that trend's momentum. They pause to catch their breath as both volume and price rate of change drop sharply. During this consolidation period, new price levels undergo continuous testing for support and resistance. To the pattern reader, this range phenomenon reveals itself through the familiar shapes of Flags, Pennants and Rectangles.

Relatively simple mechanics underlie the formation of these continuation patterns. The orderly return to a market's mean state sets the foundation for a new thrust in the same direction. In a series of sharp trend moves, congestion tends to alternate between simple and complex in both time and size. Trade defensively when the prior pattern was both short and simple. Go on the offense after observing an extended battle in the last range.

When examining continuation patterns, traders must pay close attention to proportionality. This visual element will validate or nullify other predictive observations. Constricted ranges should be proportional in both time and size to the trends that precede them. When they take on dimensions larger than expected from visual examination, odds increase that the observed range actually relates to the next trend larger in scale than the one being viewed. This can trigger devastating trend relativity errors, in which positions are executed based on patterns longer or shorter than the time frame being traded.

All patterns must be evaluated within the context of trend relativity. The existence of any range depends upon the time frame being analyzed. For example, a market may print a strong bull move on the weekly chart, a bear on the daily and a tight continuation pattern on the 5-min bar, all at the same time. A range drawn through one time frame does not signal similar conditions in the other periods that particular market trades through.

 


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