Trading Both Sides Of The Chart – Down Trends

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I began a discussion on when to use bearish positions in an earlier article. In that piece I focused on trading ranges and the use of oscillators like MACD, stochastic or RSI. Trading ranges, or the limits of those ranges, present high probability target areas in which signals can be taken, both bullish and bearish. They are also ideal situations for using overbought/oversold readings on your indicators as they often lead to and/or confirm the tops and bottoms of a ranging market. For this piece I am going to focus on an actual bear market. In general, even when we are in a secular bear market, stocks tend to go up slowly and fall quickly. It is not rare, but uncommon to find an asset in a true down trend but one you do it can provide a number of text book entries. I have been following a down trending asset for some time now, at least three years, and was inspired to write this article when I read Cory’s article about using another gold stock or index as an indicator of physical gold prices. I like to use the CBOE Gold Index, or GOX.

Long Term Down Trend In Gold

During the financial crisis of 2008-2009 the price of gold went through the roof, taking gold stocks and gold indices with them. At the peak, gold was trading over $1800, about 50% higher than the current levels. Since then, roughly 2020 or so, gold prices have fallen in a steady down trend with gold stocks moving right along with it. The down trend in the gold sector is a near perfect text book example and readily observed in numerous time frames. Along the way there are quite a few signals, bearish signals, to trade on. I know for me it was hard to learn just when to trade bearish and bullish as so many indicators can produce either form of signal at any given time. It took a while but I eventually began to understand the importance of trend, time frame and the relative value of any one signal at any one time. A bear signal in an uptrend isn’t a good place to get into a long term bearish position any more than a bullish signal in a down trend.

The first step is to identify the down trend. On the chart below it is easy to see the long term down trend in the GOX but how might you find it way back when it first started? That is the hard part and why waiting for confirmations are always a good idea. We can see that the index traded in a range during all of 2020 between two key Fibonacci Retracement levels. During this time range trading techniques and short term trend following strategies would have been a good idea. At the end of the year price broker the lower boundary, retested the moving average and produced bearish confirmation. This signal is still rather short term in nature but still a good place to buy puts, only there really isn’t a trend established yet. That happens later in 2020 when prices retest the previously broken 23.6% Fibonacci Retracement. Once that happens a well defined down trend ensues. At this time moving down to a chart of daily prices and even shorter to 1H or 30M will produce repeated trend following signals, signals identical to bullish signals, just in reverse. In fact, there are even some well defined longer trend signals as well. Look to the extreme right of the chart where I am tracking a pennant formation.

Bearish Entries For Short Term Traders

In this next chart I drill down to daily charts with a close up of the long term pennant mentioned above As we can see bearish traders are presented with a number of opportunities for entry along the boundaries of the pennant itself and the Fibonacci Retracement lines drawn on the bull trend leading to the down trend we are tracking today. There are at least, and I say at least, 16 positive bearish signals over the course of a year. This is great for patient traders with a long term outlook and also provides starting points for short term traders. Each time one of these signals appears on the daily charts that is your ticket to move down to a chart of short candles in order to capture the shorter term movements, always keeping in mind the underlying trend and taking only the bearish trades.

Studying old charts and historical price action is important to do. By studying old charts, drawing trend lines, playing with Fibonacci Retracement and identifying where the really good signals come from you get comfortable with them. This comfort level will help you with your trading because you will be better able to recognize new signals as they happen. Each new down trend will be different but in the end the market is always repeats itself and those repetitions will show up on your charts.

Introduction to Technical Analysis Price Patterns

In technical analysis, transitions between rising and falling trends are often signaled by price patterns. By definition, a price pattern is a recognizable configuration of price movement that is identified using a series of trendlines and/or curves. When a price pattern signals a change in trend direction, it is known as a reversal pattern; a continuation pattern occurs when the trend continues in its existing direction following a brief pause. Technical analysts have long used price patterns to examine current movements and forecast future market movements.

Key Takeaways

  • Patterns are the distinctive formations created by the movements of security prices on a chart and are the foundation of technical analysis.
  • A pattern is identified by a line that connects common price points, such as closing prices or highs or lows, during a specific period of time.
  • Technical analysts and chartists seek to identify patterns as a way to anticipate the future direction of a security’s price.
  • These patterns can be as simple as trendlines and as complex as double head-and-shoulders formations.

Trendlines in Technical Analysis

Since price patterns are identified using a series of lines and/or curves, it is helpful to understand trendlines and know how to draw them. Trendlines help technical analysts spot areas of support and resistance on a price chart. Trendlines are straight lines drawn on a chart by connecting a series of descending peaks (highs) or ascending troughs (lows). A trendline that is angled up, or an up trendline, occurs where prices are experiencing higher highs and higher lows. The up trendline is drawn by connecting the ascending lows. Conversely, a trendline that is angled down, called a down trendline, occurs where prices are experiencing lower highs and lower lows.

Trendlines will vary in appearance depending on what part of the price bar is used to “connect the dots.” While there are different schools of thought regarding which part of the price bar should be used, the body of the candle bar—and not the thin wicks above and below the candle body—often represents where the majority of price action has occurred and therefore may provide a more accurate point on which to draw the trendline, especially on intraday charts where “outliers” (data points that fall well outside the “normal” range) may exist. On daily charts, chartists often use closing prices, rather than highs or lows, to draw trendlines since the closing prices represent the traders and investors willing to hold a position overnight or over a weekend or market holiday. Trendlines with three or more points are generally more valid than those based on only two points.

  • Uptrends occur where prices are making higher highs and higher lows. Up trendlines connect at least two of the lows and show support levels below price.
  • Downtrends occur where prices are making lower highs and lower lows. Down trendlines connect at least two of the highs and indicate resistance levels above the price.
  • Consolidation, or a sideways market, occurs where price is oscillating between an upper and lower range, between two parallel and often horizontal trendlines.

Continuation Patterns

A price pattern that denotes a temporary interruption of an existing trend is known as a continuation pattern. A continuation pattern can be thought of as a pause during a prevailing trend—a time during which the bulls catch their breath during an uptrend, or when the bears relax for a moment during a downtrend. While a price pattern is forming, there is no way to tell if the trend will continue or reverse. As such, careful attention must be placed on the trendlines used to draw the price pattern and whether price breaks above or below the continuation zone.   Technical analysts typically recommend assuming a trend will continue until it is confirmed that it has reversed. In general, the longer the price pattern takes to develop, and the larger the price movement within the pattern, the more significant the move once price breaks above or below the area of continuation.

If price continues on its trend, the price pattern is known as a continuation pattern. Common continuation patterns include:

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  • Pennants, constructed using two converging trendlines
  • Flags, drawn with two parallel trendlines
  • Wedges, constructed with two converging trendlines, where both are angled either up or down

Pennants

Pennants are drawn with two trendlines that eventually converge. A key characteristic of pennants is that the trendlines move in two directions—that is, one will be a down trendline and the other an up trendline. Figure 1 shows an example of a pennant. Often, volume will decrease during the formation of the pennant, followed by an increase when price eventually breaks out.

Flags

Flags are constructed using two parallel trendlines that can slope up, down or sideways (horizontal). In general, a flag that has an upward slope appears as a pause in a down trending market; a flag with a downward bias shows a break during an up trending market. Typically, the formation of the flag is accompanied by a period of declining volume, which recovers as price breaks out of the flag formation.

Wedges

Wedges are similar to pennants in that they are drawn using two converging trendlines; however, a wedge is characterized by the fact that both trendlines are moving in the same direction, either up or down. A wedge that is angled down represents a pause during a uptrend; a wedge that is angled up shows a temporary interruption during a falling market. As with pennants and flags, volume typically tapers off during the formation of the pattern, only to increase once price breaks above or below the wedge pattern.

Triangles

Triangles are among the most popular chart patterns used in technical analysis since they occur frequently compared to other patterns. The three most common types of triangles are symmetrical triangles, ascending triangles, and descending triangles. These chart patterns can last anywhere from a couple weeks to several months.

Symmetrical triangles occur when two trend lines converge toward each other and signal only that a breakout is likely to occur—not the direction. Ascending triangles are characterized by a flat upper trend line and a rising lower trend line and suggest a breakout higher is likely, while descending triangles have a flat lower trend line and a descending upper trend line that suggests a breakdown is likely to occur. The magnitude of the breakouts or breakdowns is typically the same as the height of the left vertical side of the triangle, as shown in the figure below.

Cup and Handles

The cup and handle is a bullish continuation pattern where an upward trend has paused, but will continue when the pattern is confirmed. The “cup” portion of the pattern should be a “U” shape that resembles the rounding of a bowl rather than a “V” shape with equal highs on both sides of the cup. The “handle” forms on the right side of the cup in the form of a short pullback that resembles a flag or pennant chart pattern. Once the handle is complete, the stock may breakout to new highs and resume its trend higher. A cup and handle is depicted in the figure below.

Reversal Patterns

A price pattern that signals a change in the prevailing trend is known as a reversal pattern. These patterns signify periods where either the bulls or the bears have run out of steam. The established trend will pause and then head in a new direction as new energy emerges from the other side (bull or bear). For example, an uptrend supported by enthusiasm from the bulls can pause, signifying even pressure from both the bulls and bears, then eventually giving way to the bears. This results in a change in trend to the downside. Reversals that occur at market tops are known as distribution patterns, where the trading instrument becomes more enthusiastically sold than bought. Conversely, reversals that occur at market bottoms are known as accumulation patterns, where the trading instrument becomes more actively bought than sold. As with continuation patterns, the longer the pattern takes to develop and the larger the price movement within the pattern, the larger the expected move once price breaks out.

When price reverses after a pause, the price pattern is known as a reversal pattern. Examples of common reversal patterns include:

  • Head and Shoulders, signaling two smaller price movements surrounding one larger movement
  • Double Tops, representing a short-term swing high, followed by a subsequent failed attempt to break above the same resistance level
  • Double Bottoms, showing a short-term swing low, followed by another failed attempt to break below the same support level

Head and Shoulders

Head and shoulders patterns can appear at market tops or bottoms as a series of three pushes: an initial peak or trough, followed by a second and larger one and then a third push that mimics the first. An uptrend that is interrupted by a head and shoulders top pattern may experience a trend reversal, resulting in a downtrend. Conversely, a downtrend that results in a head and shoulders bottom (or an inverse head and shoulders) will likely experience a trend reversal to the upside. Horizontal or slightly sloped trendlines can be drawn connecting the peaks and troughs that appear between the head and shoulders, as shown in the figure below. Volume may decline as the pattern develops and spring back once price breaks above (in the case of a head and shoulders bottom) or below (in the case of a head and shoulders top) the trendline.

Double Top

Double tops and bottoms signal areas where the market has made two unsuccessful attempts to break through a support or resistance level. In the case of a double top, which often looks like the letter M, an initial push up to a resistance level is followed by a second failed attempt, resulting in a trend reversal. A double bottom, on the other hand, looks like the letter W and occurs when price tries to push through a support level, is denied, and makes a second unsuccessful attempt to breach the support level. This often results in a trend reversal, as shown in the figure below.

Triple tops and bottoms are reversal patterns that aren’t as prevalent as head and shoulders or double tops or double bottoms. But, they act in a similar fashion and can be a powerful trading signal for a trend reversal. The patterns are formed when a price tests the same support or resistance level three times and is unable to break through.

Gaps occur when there is empty space between two trading periods that’s caused by a significant increase or decrease in price. For example, a stock might close at $5.00 and open at $7.00 after positive earnings or other news. There are three main types of gaps: Breakaway gaps, runaway gaps, and exhaustion gaps. Breakaway gaps form at the start of a trend, runaway gaps form during the middle of a trend, and exhaustion gaps for near the end of the trend.

The Bottom Line

Price patterns are often found when price “takes a break,” signifying areas of consolidation that can result in a continuation or reversal of the prevailing trend. Trendlines are important in identifying these price patterns that can appear in formations such as flags, pennants and double tops. Volume plays a role in these patterns, often declining during the pattern’s formation, and increasing as price breaks out of the pattern. Technical analysts look for price patterns to forecast future price behavior, including trend continuations and reversals.

Keep It Simple and Trade With the Trend

As a trader, you have probably heard the old adage that it is best to “trade with the trend.” The trend, say all the pundits, is your friend. This is sage advice as long as you know and can accept that the trend can end. And then the trend is not your friend.

So how can we determine the direction of the trend? We believe in the KISS rule, which says, “keep it simple, stupid!” Here is a method of determining the trend, and a simple method of anticipating the end of the trend.

Before we get started, we want to mention the importance of time frames in determining the trend. Usually, when we are analyzing long-term investments, the long-term time frame dominates the shorter time frames. However, for intraday purposes, the shorter time frame could be of greater value. Trades can be divided into three classes of trading styles or segments: the intra-day, the swing, and the position trade.

Large commercial traders, such as those companies setting up production in a foreign country, might be interested in the fate of the currency over a long period of such as months or years. But for speculators, a weekly chart can be accepted as the “long-term.”

Averages Moving in Pairs

With a weekly chart as the initial reference, we can then go about determining the long-term trend for a speculative trader. To do this we will resort to two very useful tools that will help us determine the trend. These two tools are the simple moving average and the exponential moving average.

Chart 1: May 2006-July 2008

In the weekly chart above, you can see that for the period of May 2006 until July 2008 the blue 20 interval period exponential moving average is above the red 55 simple moving average and both are sloping upward. This indicates the trend is showing a rise of the euro and therefore a weakening dollar.

In August 2008, the short-term moving average (blue) on the chart below turned down, indicating a potential change in trend although the long-term average (red) had not yet done so.

Finding the Change in Trend

In October, the 20-day moving average crossed over the 55-day moving average. Both were then sloping downward. At this point, the trend has changed to the downside and short positions against the euro would be successful.

Chart 2: October Short-Term Moving Average

Still looking at Chart 2, we notice that the short-term moving average goes relatively flat in December 2008 and starts to turn up, now indicating a potential change in trend to the upside. But a closer look at the 55-day moving average, as of December 2008, shows that the long-term moving average has remained downward sloping.

By checking Chart 2, we can see that the first arrow from the left indicates that the long-term moving average has turned down, indicating that the weekly or longer term trend for the EUR/USD has now gone down. The second arrow indicates where a new short position could have been successfully taken once the price had traded back to the down sloping moving average.

The goal here is to determine the trend direction, not when to enter or exit a trade. Of course, this is not to say that there were no trading opportunities in the shorter time frames such as the daily and hourly charts. But for those traders who want to trade with the trend, rather than trading the correction, one could wait for the trend to resume and again trade in the direction of the trend.

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