Chart Analysis – Bottoming Formations Part 1

09/13/2007 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Often times beginning traders focus on using a series of computerized technical indicators to select their trades. However, they soon realize that without a solid background in chart analysis, they are at a disadvantage. In this series of articles, I will discuss the basics of chart analysis.

Traditional chart analysis can give the investor or trader a graphical picture of the supply/demand characteristics of a market. The price formations can be classified into several categories. Those associated with major trend reversals include head-and-shoulder formations, rounded tops and bottoms, and double and triple tops and bottoms. Continuation patterns, which include triangles, wedges and rectangles, represent pauses within the dominant trend. Continuation formations on weekly charts are particularly important for traders, as the resulting price moves can often be dramatic and the risk can often be well-controlled. One tool that chartists can use to help narrow their focus is the study of the industry group charts, which were not readily available to most early chartists.

If you look at the top performing groups of the past two years, you will find some interesting examples of major bottom formations. When most chartists think of a head-and-shoulders formation, they think of it as a top, but the opposite of this is called a reverse head-and-shoulders, which is a bottoming formation. The weekly chart of the S&P Railroads (Figure 1) goes back to 1995, and is an example of a reverse head-and-shoulders bottom formation. If you are not sure you see the formation at first, turn the chart upside down and it might be easier to see. Chart formations always have to be viewed in the larger context and that is why I focus first on the weekly charts. Daily chart formations can often be incorrectly interpreted if the weekly charts are not studied as well.

The key ingredients for a reverse head-and-shoulders bottom formation are a left shoulder, where volume should be the highest, then the head (a significant new low in price), followed by a right shoulder where the level of the left shoulder is reached or exceeded, but volume is lower. A neckline can then be drawn and a break through the neckline confirms that the formation is complete.

Figure 1

Over the past two years, the railroads have been one of the top ten industry groups, up 110%, and for the past six months they are up 35%. The weekly chart goes back to late 1995 and shows a reverse head-and-shoulders bottom formation that took almost eight years to develop. The left shoulder (LS) was formed in September 1998 as the 142 area was reached. This set the stage for a rebound back to the resistance in the 196 area in May 1999. The next decline dropped the index below the previous low, as the 110 level was slightly broken to form the head of the reverse head-and-shoulder formation. Of course, it would be over four years before this was confirmed. During early 2001, the index again approached the 190 level before dropping to 130 in September 2001. This has been labeled the right shoulder (RS) and often times the right shoulder level is lower than the left shoulder.

The index then rallied sharply in early 2002, briefly exceeding the 190 level before turning lower once more. At this point one could have realized that a reverse head-and-shoulder bottom formation might be forming with the neckline and strong resistance at line A. The ensuing decline took prices back to the 140 level, which could have been labeled as a second right shoulder. It was significant that the index held above the prior RS lows as it suggested less selling pressure. The S&P Railroads Index moved sharply through the neckline (line A) in September 2004, completing the bottom formation.

Many charting formations can be used to determine potential price targets, and while these are often exceeded, especially when calculated using weekly data, they do allow one to gauge the risk/reward of a given trade. For the reverse head-and-shoulder formation, one takes the distance from the head to the neckline (line B) and then measures up the same distance from the breakout point to get the price objective. In this case, when the neckline was overcome, the projection was for a rally from the 190+ level to 290, or about a 50% gain. As noted on the chart, the rally has continued, with the index closing the week of March 17 at 362.50.

One important ingredient that can confirm the chart formations is volume, which unfortunately is not available on the S&P Indexes. The ideal volume pattern for a reverse head-and-shoulder bottom formation is for volume to be heaviest at the left shoulder and then lower at the head, decreasing more as the right shoulder is formed. Then, on the move through the neckline, volume should expand significantly. In the real world, all of these criteria are not always met.

Figure 2

Though it is not always the case, often times you see similar formations in the individual stocks as you observe in the industry indices. Burlington Northern (BNI), one of the railroad stocks, also shows a reverse head-and-shoulder bottom formation. The left shoulder (LS) was formed in April 1997 and the volume on the decline was quite high (see circle). BNI then rallied from the lows near $23 to over $37 in the next two years, peaking in May 1999. The following reversal was even more severe as the stock declined for the next year dropping to under $20 in March 2000. Volume was even heavier on this decline than on the left shoulder. This is not what one would expect in a classic reverse head-and-shoulder bottom formation.

BNI again moved higher, peaking in May 2001 at $34. This high formed the second point for the neckline (line A). On the decline in the latter part of 2001, the stock price held well above the 2000 lows, forming the first right shoulder (RS1). Volume did increase on this decline, but was lower overall than that seen at the LS or Head. Volatility again contracted over the next 18 months and BNI formed a second right shoulder (RS2) in March 2003. There was even less volume corresponding with this low (see circle), consistent with lower selling pressure. The neckline (line A) was tested first in June 2003 and again in September. It was overcome in late 2003 and the volume expanded as prices rallied, breaking the downtrend in volume (line C) by the middle of 2004. The measured target from the formation (adding the length of line B to the breakout point) suggested a rally from $30 to $48 per share. This target was reached by the end of 2004. However, as is often the case, this was just a minimum upside target, as BNI has surpassed the $81 level in early 2006.

Chart analysis is more of an art than a science, and two analysts may have different names for a given formation, but it is the conclusion that is important. If the conclusion is the same, then the name used is less important. Rounded bottom formations can have many different forms, and some head-and-shoulder bottom formations are called rounded bottoms, usually when the shoulders or neckline are not well defined.

Figure 3

Norfolk Southern (NSC) is another railroad stock that falls into this category. NSC after peaking in mid-199 had a precipitous decline, dropping from $36.50 to $12.68 in March 2000 (point 1). Volume was heavy on the lows. The stock then rebounded, almost reaching the $20 level before a new wave of selling took it to a new low of $12 on October 20, 2000 (point 2). Volume on the new lows was significantly less than on the prior low, as indicated by line A. As NSC rallied, volume expanded (line B), which was an encouraging sign. Though the $20 level was overcome on this rally, it fell short of the stronger resistance at $27. In the latter part of 2001, NSC again turned lower, but this time it held well above the prior two lows (point 3). Volume was even lower than at points 1 and 2. This suggested that demand was coming in at these lower levels

Volume surged as NSC turned higher and the first band of resistance at $27 was reached. If you were just looking at a daily chart you might have been oblivious to the strong band of overhead supply (resistance) between $27 and $36.50. As it turned out, it would be another two-and-a-half years before the resistance at $27 was overcome as NSC moved above $27 in August 2004, one month before the railroad index.

As was the case with the railroad index, early identification of an intermediate term low in the industry group would have allowed the trader to focus in on those stocks that have been the recent stellar performers. In the next article we will continue to look at bottom formations, with more examples of rounded bottoms as well as double bottoms and falling wedges.

Tom Aspray began doing computer analysis of the financial markets in the early 1980s. He helped to introduce many of the technical tools that are now very popular though his writings and lectures around the world. He now works as a private consultant and educator. He would welcome your comments and suggestions at tomaspray@intershow.com.

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