Trading the “Falling Three” Method

02/10/2010 9:47 am EST

Focus: STRATEGIES

The PowerShares QQQ Trust (QQQQ) daily chart was on an unsustainable path as a multi-month accelerated trend line formed from the November low (Figure 1).

Prices peaked in early January at $46.64 just as a bearish rising wedge pattern was developing. Just two sessions after prices peaked, the accelerated trend line ruptured, resulting in a bearish breakout of the rising wedge chart pattern as prices collapsed below the 20-day moving average (MA).

QQQQ continued to drop through the 50-day MA as a precursor to testing the lower channel line.

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The falling wedge continuation pattern formed after the channel broke, suggesting the pattern may carry prices lower to complete a neckline of a speculative head-and-shoulders top.

The above chart reveals that by the end of January, the bears managed to shatter the lower channel line as QQQQ continued in self-destruct mode. But immediately after the channel broke, the selling temporarily halted as QQQQ filled the gap from November. The gap fill spurred a lackadaisical rally fueled by light volume, carrying prices back up to the broken lower channel line as the bulls tried to salvage the previous advance.

But as prices tagged the broken channel line, the bears pounced on prices again, causing them to reverse course. That reversal resulted in the completion of a bearish falling three methods candle pattern. According to Greg Morris in his marvelous book, Candlestick Charting Explained, "The falling three methods pattern is the bearish counterpart of the rising three methods pattern"-a continuation pattern.

According to Morris, the falling three methods candlestick pattern begins with elongated candlestick forms in the direction of the current trend. That's followed by three sessions of small real-bodied candles that rise in the opposite direction of the trend. The three bodies are usually contained within the high-low range of the first candle. The last day of the pattern produces another long candle that usually closes below the first day's candle of the five-day pattern.

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After a break in trend and a drop below key moving averages, prices do the side step to form a falling three methods continuation pattern. Note how the three-day rally sandwiched between the bearish bars and failed to clear the first day's bar.

In the example in Figure 2, the falling three methods pattern possesses all of these characteristics, from all three sessions staying within the trading range of the first candle to the last candle in the pattern breaking to a fresh low.

The bearish falling three methods continuation pattern will more than likely be the vehicle that will be used to continue to drive prices lower near the proximity of the $40.50 area, which is the neckline of a speculative large head-and-shoulders topping pattern. Once there, the bulls may try to spearhead an effort to take prices back up to form a right shoulder in order to complete the pattern. If the right shoulder is to have symmetry with the left shoulder, prices may peak just below the $44 area.

By Ron Walker of TheChartPatternTrader.com

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