Traders Study Stock Price and Volume Patterns
The technician looks for price and volume patterns that suggests the possible initiation or continuation of a trend. Let's discuss a few triangle formations as examples. There are three basic triangle formations. There are symmetrical, ascending, and descending triangles. A symmetrical triangle is the description of one of the price patterns a stock can form during a time of price consolidation (sometimes referred to as "congestion") after a significant move. Imagine a stock that moves up 15 points from $50 to $65 within a week. Then imagine that the stock goes sideways for maybe six weeks. A symmetrical triangle forms when each day after reaching the high point of its recent surge the high for the day is lower than the high of the previous day. In other words the highs are progressively lower. At the same time, the lows are progressively higher. If you were to draw a line connecting the lows and another line connecting the highs, they would form a symmetrical triangle with the base being formed by the last part of its recent surge from $50. The apex of the triangle would be pointing to the right..
Eventually, the stock's price will break out of the triangle. When it does, the stock is more likely than not to move in the same direction in which it was moving during the previous surge. However, that is not always the case, especially if the upper and lower boundaries of the triangle are not equal. Most of the time, look for the breakout to occur on the direction of the slope of the boundary that is longer. In any event, a breakout to the upside should be confirmed by a surge in volume. A breakout to the downside does not need a volume confirmation. With such patterns, the probabilities favor a breakout to the upside. Look for a volume surge to confirm the breakout move.
An ascending triangle is similar except that in an ascending triangle, the highs are at approximately the same level, but the lows are progressively higher. When the consolidation pattern takes this configuration the breakout tends to be in the same direction as the hypotenuse (the longer side) of the triangle. Just think of the hypotenuse as an arrow pointing in the direction of the coming breakout. With some congestion patterns after a significant move, it is the lows rather than the highs that are at approximately the same price and the highs are progressively lower. In this case, the hypotenuse is pointing downward and the coming breakout is likely to be to the downside.
Bear in mind that the above are generalizations. Sometimes the stock will break out in the unexpected direction. The traders at stockdisciplines.com have learned that the actual breakout is more reliable as an indicator of the next trend than is the shape of the triangle. A stock that has risen $15 from $50 in one week may then create a rising triangle. Though the hypotenuse is pointing up, the stock may break out to the downside. Though this is not the normal expectation, it does happen. For example, assume that a company has created "Drug X" as a cure for cancer. Assume that the FDA has Drug X under review. The stock may surge on anticipation of approval and then consolidate in a rising triangle formation. Because the lows are getting higher, we would expect a breakout to the upside. However, suppose the FDA concludes that they will need more data before approving the drug. The breakout will now likely be to the downside.
There are volume patterns that broadcast the "intentions" of the stock. For example, assume you are looking at an ascending triangle configuration, and you want further evidence that the stock "intends" to break out to the upside. If the volume increases when the stock moves up and decreases when it moves down, you are being told that there is more buying enthusiasm behind the up moves than selling enthusiasm behind the down moves. That would confirm the stock's intention to move higher on its breakout. If volume tended to dry up on the up moves and increase on the down moves, you are being warned that you cannot trust that the stock will break out to the upside.
Suppose you want to buy a stock that surged and subsequently formed a rising triangle. The odds are that the breakout will be to the upside. However, that is not certain. Instead of buying the stock on the assumption of an upside breakout and surge in price, you could place a stop order to buy at some price just above the expected breakout price. If the stock breaks to the downside instead, then you have not committed yourself to a declining stock. You will buy only if the stock actually breaks out to the upside.
Dr. Winton Felt maintains a variety of free tutorials, stock alerts, and scanner results at www.stockdisciplines.com has a market review page at www.stockdisciplines.com/market-review has information and illustrations pertaining to pre-surge "setups" at www.stockdisciplines.com/stock-alerts and information and videos about volatility-adjusted stop losses at www.stockdisciplines.com/stop-losses