Chart Analysis – Bottoming Formations Part 2

10/11/2007 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

In the last article we looked at reverse head-and-shoulder bottom formations and also introduced rounded bottom formations. Though many traders do not realize it, the best trading opportunities often come from the study of weekly charts. Why? When you identify a stock or index that has completed a major bottom or top, or one that is already in a solid up- or downtrend, it will often provide a number of good trading opportunities for weeks, if not months. For some, the concepts of support and resistance, which are essential to chart analysis, can be difficult to understand.

Oftentimes, one can better understand resistance on a bar chart by thinking of it as a price level that someone in the past paid for the stock. When the stock makes it back to that price (resistance) they can finally sell and get out even. For many who have been stuck at a loss for several months or years, this is quite a relief. As for support, one can think of it as a price that in the past has been attractive as demonstrated by the stocks ability to hold that level and move higher. Volume patterns also play a key role: if a stock declines to a support level on low volume, then turns higher on increasing volume, it is an indication that demand supports the price.

If you hear about a stock or market on the news or from someone at a social gathering, you can almost be certain that there was a good technical reason for it to move higher or lower, and for it to be worth talking about. Both the energy markets and the Japanese stock markets have been hot topics recently, and their charts both show examples of falling wedge formation, which are a type of triangle formation. These formations are common in the financial markets, so it is important that the trader and/or investor can identify and interpret them.

A triangle formation is identified by two lines: the support line connecting lows, and the resistance line connecting highs. The triangle is formed when one of these two lines has a steeper slope than the other, and it looks as though they will intersect. A falling wedge formation is a major reversal pattern that is characterized by a relatively steep downtrend line (resistance) and a line that connects lower lows on the chart (support). The differences in the slopes of these two lines will cause them to meet at some future point in time. In a falling wedge formation, the volume should be declining as the support line is reached, and then begin to increase dramatically when resistance is overcome. A rising wedge, which we will discuss in future articles, is a top formation where the demand line (support) has a steeper slope than the resistance line. Other triangles frequently observed are a type of continuation pattern, that is, a pause or interruption in an up- or downtrend.

Figure 1

The weekly chart of the crude oil futures shows two different falling wedge formations that were resolved to the upside in early 1999. The two-year downtrend (line A) forms the upper boundary of the wedge formation and goes back to the highs in 1997. The lower boundary of the wedge formation (line B) connects the 1998 lows. On the chart one can also see a shorter-term downtrend (dashed line) that is drawn from the 1997 and 1999 peaks. The move through this resistance (point 1) was the first indication that the bottom formation had been completed. The volume had declined as crude dropped below $10 per barrel, but then increased as the first resistance was overcome (point 2). Volume was even higher, as crude oil prices surpassed the stronger resistance at line A. The ensuing rally took crude oil prices up to the $40 level in 2000. As we are all painfully aware, the rally has continued for the past six years.

Figure 2

The weekly chart of the ETF iShares MSCI Japan Index (EWJ) gives us another excellent example of a falling wedge formation. The weekly chart shows a more severe wedge formation, lines A and B, than the crude oil chart. It is also significant that the support line (red) connects three different lows in price. Because these were just marginal new lows, it indicated a lessening of the selling pressure, as did the low volume. As EWJ moved through its two-year downtrend in June of 2003 (point 1), the volume increased significantly as indicated by the red circle, labeled C.

Figure 3

Falling wedges are just one type of triangle formation observed in the financial markets, so it’s nice that there are quite a few useful ways to determine price targets from triangle formations. Each of these involves taking a measurement, usually at the middle of the formation, and then taking another at its widest point. We have shown this graphically (Fig. 3) in the daily chart of the iShares MSCI Japan Index (EWJ). The daily chart shows an expanded falling wedge formation (lines A and B). I have measured the width of the formation at the widest point (dashed line a) and in the middle (dashed line b). These distances are then measured up from the breakout point, which gives you two different price projections. The first target, using line b, is in the $9.70 area (point 2), while the second, using line a, is in the $11.50 area (point 1). The $11.50 area corresponds very nicely to the 2004 highs and was a significant barrier, which took over a year to overcome. These price projections should be used to determine the risk/reward of a trade, with the lower projection (point 2) being the minimum upside target, and the higher projection (point 1) being seen as a reasonable goal for the trade. I feel that a chart analysis such as this, which takes into account the risk/reward of a trade, is an essential part of money management.

Figure 4

The steel stocks have also been one of the strong performers of the past two years as the S&P Steel index is up 160%. As we discussed in the last article when we looked at the Railroad Index and Burlington Northern, watching the chart formations in the group indices can help you pinpoint the stocks to watch. The falling wedge formation, lines A and B, took five years to complete, but for those who have owned the steel stocks over the past few years, it was worth the wait. This formation was completed in late 2003. The upside targets from this formation were determined by measuring the distance from the 1998 high to line B (dashed line a) and then the width in the middle of the formation (dashed line b). The first target, using line b, was in the 97 area (point 1) and the second from line a, was in the 115 area (point 2). This second target was met in late 2004, and just this past week, the S&P Steel Index surpassed the 210 level.

Figure 5

If you had been watching the formation of the falling wedge in the Steel Index you might have found AK Steel Holdings (AKS). Both the resistance (line A) and the support (line B) are made up of three points and AKS was very near the apex of these lines when the downtrend was decisively broken (line C). Breakouts that come near the apex of a triangle formation are often suspect, but volume did increase nicely at line C, and was even stronger as the rally resumed four weeks later. The wedge formation gave us two upside targets from the breakout in the $2.50 area. The first (line b) was in the $11.50 area, point 1, while the second (line a) was at $15.50, and was met in late 2004.

As you have probably heard before, the financial markets are cyclical, and this, I believe, is also true with regard to chart formations. At one cyclical market bottom, reverse head-and-shoulder formations may be dominant and at the next it could be falling wedges. Therefore, I feel it is important that one is familiar with all common chart formations. In the next article, I will look at double bottom formations, as well as bottom formations on the daily 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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