Chart Analysis – Top Formations Part 2

12/20/2007 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Top formations are always easy to identify in retrospect, especially if you are still holding on to your long positions. In this article, I hope to not merely show you examples of common top formations, but also to give you some tips for identifying them as they are occurring.

There are some common mistakes that traders and investors make in regard to top formations. The most common of these is that the trader ignores mounting evidence that an uptrend is weakening, and then, as the market continues to drop, hopes for a rebound instead of objectively analyzing the situation. As the decline persists (everything in the markets takes longer than you expect) fear steps in, causing some to sell out near the lows. One of the best warnings that a market or stock’s trend has changed is the simple breaking of a well-defined uptrend. As I have discussed previously, the longer the uptrend, the more significant the signal. Often times, the break will occur before the ultimate rally highs, yet even while the rally continues, the trend line break tells us that something has changed.

As I have emphasized in past articles, you can limit your ability to become a successful trader if you do not look at charts of multiple time frames. In the previous article, we looked at weekly top formations including head-and-shoulders and double top formations. The completion of a weekly top generally warns of a decline that will last many months, if not several years. Of course, these tops are also recognizable on the daily charts, but the appearance of a top on the daily chart could simply signal a correction, unless it is confirmed with a weekly top. The first example I would like to look at is the daily chart of Intel (INTC), covering late 2003 and early 2004. However, in order to put the daily chart in proper perspective, we must first examine longer-term pictures of the stock’s activity.

Figure 1

Intel completed a rising wedge formation, lines A and B, in September 2000 when the nine month uptrend, line B, was broken (point 1). Rising wedges, like falling wedges, often lead to very dramatic price moves. As the rising wedge is forming, volume should contract as the stock continues to move higher (line A). This was the case for INTC, as the volume bars formed lower highs; line C, as INTC peaked at $75.81. You will note that the volume turned up sharply as the wedge formation was completed (point 2), which confirmed the trend line break. The ensuing slide took INTC to a low of $18.96 one year later. On the rebound into early 2002, INTC reached a high of $36.78, which then became significant resistance. During the next decline, there was further selling as INTC made a low of $12.95 in October 2002.

Figure 2

Another decent rally got underway in early 2003 and INTC had a well-established uptrend from the July and August lows (line A). As INTC moved higher the volume began to diverge: at the October 2003 high at $34.51 (point 1), the volume (circle 1) was lower than it had been at prior peaks. The daily uptrend did hold on the pullback, but on the next rally, INTC peaked at $34.40 (point 2) and then dropped sharply, violating its uptrend, line A. This was the first indication that a trend change was occurring. Though many might not have wanted to close out their entire position on this trend line break, selling at least part of their position would have been prudent from a money management standpoint. The support at $29.66 (line B) did hold, as once again INTC attempted to challenge the previous highs. INTC made a higher intra-day high at $34.60 (point 3) but then closed well below the highs. A seasoned trader at this point would have realized that the resistance from the January 2002 highs at $36.78 had come into play and that a triple top could be forming. Clearly the risk on the long side had increased significantly and, with three failed rally attempts, a short position with a stop above $36.78 had a favorable risk/reward ratio.

In a triple top formation, volume should be greatest on the first high and then decline as subsequent peaks are formed. Another thing to watch for is an increase in volume as the stock turns down. This was the case for INTC, as indicated by the red circles labeled 1, 2, and 3. The triple top formation was completed when support at line B was broken in February 2004 at point 4. Volume did increase, as this support was broken, indicating that there was significant selling pressure. Take a look at Figure 1, and you will see that the weekly uptrend line D was broken the prior week, giving advance warning of a trend change. In 2004, INTC eventually dropped below the $20 level.

Figure 3

Boeing (BA) had a dramatic rise in 2000 as it went from a low of $32.31, to a high in December of $70.93. After the sharp pullback in October, one could have drawn a fairly steep uptrend (dashed line B), which would become the lower boundary of a rising wedge formation. Boeing made a series of higher highs in October through December, line A, as it gradually moved above the $70 level. The heaviest volume occurred in September (circle 1) and then, as BA moved higher, the volume declined (circles 2 and 3). The declining volume, combined with the marginal new highs, is consistent with a weakening uptrend. On December 20, 2000, the uptrend was broken and after a two-day decline, BA rallied and just tested its former uptrend (point 5) before turning lower. This is a classic formation and was a perfect opportunity to either sell long positions, or to sell short. BA then dropped to the $54.56 level before it was able to stage a rally. The ensuing rebound lasted five weeks and took BA back to resistance in the $65.60 area (line C).

Figure 4

All of the formations we have discussed in the previous articles can also be found on the intra-day charts; this hourly chart covers the S&P 500 from April through early June of 2006. After the April highs at 1318.16, the S&P gradually moved higher and, by the start of May, had developed a well-established uptrend from the April lows, line B. The S&P finally pushed above the 1320 level on May 5 th, but over the next two days was unable to make further upside progress, as indicated by line A. It should be noted as the index moved higher, the volume declined (line C). On May 11 th, support at line B was broken (point 1) and volume increased. This pushed the S&P down to the 1284 level. The S&P 500 stabilized for a couple of days, shown by a brief continuation in the hourly chart (circle D), but soon the sellers again took over.

After the S&P dropped another 40 points, a more easily identified continuation pattern developed. Remember, these patterns are just interruptions in the existing trend, which at that time was down. The flag formation, lines E and F, took the S&P back to the resistance from the previous continuation pattern, which was in the 1290 area. This is a fairly common occurrence. The violation of support at line F (point 2) completed the flag formation and signaled the resumption of the decline. The flag had a width of 30 points, so after the support at 1270 was broken, the downside target in the 1240 area was exceeded in just three days.

I hope that this series of articles on chart analysis has encouraged you to further study charts on your own. Chart analysis in hindsight is much easier than doing it in real-time. Real-time chart analysis takes consistent effort and continual monitoring of the issues in your portfolio. I would recommend keeping weekly and daily charts of all items in your portfolio and taking the time each weekend to update your charts.

As always I welcome your feedback on these articles. I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow's moneyshow.com video network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

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