What’s a Market Trend?

● A market trend is a directional price move.

○ For e.g., a trend in volume, in market internals i.e. number of stocks making new

highs vs new lows, in number of stocks trading above their 200 dma etc..

● TA is based on the following foundations:

○ The market is a discounting mechanism i.e. it discounts the past and anticipates

future events in its price discovery process.

○ An understanding of market structure will enable you to use the past history to

determine potential future outcomes for a trade.

○ Prices move in trends, whereby once a trend is established it becomes more

likely to continue than it is to reverse.

○ History repeats itself.

● An Uptrend is a price move from a specific low point.

● A Downtrend is a price move from a specific high point.

● Primary role of Tech Analysis is to study trends!

● Key questions:

○ What’s the trend direction?

○ How long might the trend last?

○ How strong is the trend?

○ How do I identify optimal points of entry to participate in a trend’s movement?

 ○ What signals to spot that may indicate trend weakening or changing direction?

○ Is this a good time to enter into the trend?

○ When should I exit a trend?

Charting Topics & their Roles in Trend Analysis

● Gaps: They often occur at (i) the beginning (breakaway gap), middle (continuation gap),
or end (exhaustion gap) of a trend. They reflect the start, acceleration or end of a trend
respectively. Morning Gaps play an important role in Short-Term trends.

● Volume & Volatility: Both tend to rise during trending periods and fall during periods of
consolidation.

● Classic Reversal Patterns: Common to see these patterns form at the end of a trend
and may potentially signal a trend reversal. For e.g. a Double Top may form at the end
of an uptrend or Double Bottom toward the end of downtrend.

● Classic Continuation Patterns: May form within a trend stalling its movement for a
short period of time (e.g. a flag or pennant) or for a longer duration (a triangle or trading
range).

● Candlestick Patterns: Reveal the sentiment of market participants as a trend develops.

A bearish or bullish reversal pattern may form at the end of an up or down trend
respectively.

● Price Swings: Minor wavelike price movements create the peaks and bottoms that are
the building blocks of intermediate-term trends. Such price swings may provide
opportunities for short-term trades and profit-taking opportunities for long-term positions.

● Corrections: These are retracements of the prior trend.

● Trendlines: Used to determine the (i) direction, (ii) slope and (iii) duration of a trend
(sloped lines), and highlight support & resistance areas (horizontal lines). Break of a
strong trendline can be a key signal about the potential continuation or reversal of a
trend.
 ● Technical indicators: Some indicators can help pinpoint when a trend may be
weakening. For e.g. a divergence between price and a strong indicator may occur,
warning of a potential trend reversal.

● Market Indicators: Market breadth readings (internals) may be checked to gauge the
day-to-day strength of the market trend, as well as cumulative market indicators for
monitoring longer trends.

● Trading Strategies: Many trading strategies are based on the fact that markets trend.
The success of setups traded and strategies employed at any given time may depend
greatly on the trend or lack of one within the broad market.

Key Skills for Profiting from Market Trends

● Identify a trend as early as possible in its development so as to maximize profit from the
trend’s movement.

● Determine a trend’s strength and potential duration by continuously monitoring its

strength.

● Recognise technical events and price formations that occur within a trend that may offer
trading opportunities.

● Identify signs that a trend may be weakening or reversing direction in order to protect
profits and/or get aboard a new trend when a change in direction occurs.

● Understanding the concept of support and resistance and its role in a trend’s evolution.

● Should devote most focus on monitoring trends of the stocks, major market averages,
sectors and industry groups.

1. Assessing Trend Direction

● Markets can either trend up/down or move sideways (consolidation or trading range).
 ● Useful to stay informed on the fundamental reasons why the market may be trending or
consolidating, which in turn can help explain certain charting phenomena.

○ Quotes by John Murphy: “Knowing the reasons behind a stock’s movement is

interesting, but not critical. If your stock goes up on a given day, they won’t take
the money away from you if you don’t know why it went up. And if you can
explain why it went down, they won’t give you back your lost money”

○ “The trick to visual investing is learning to tell the difference between what is
going up and what is going down.”

● 3 charting concepts for determining trend direction:

○ Price peaks and bottoms

○ Moving averages

○ Trendlines

Price Peaks & Bottoms

● Price peaks & bottoms are pivots that form on charts i.e. they show where price turned
resulting in at least a temporary change in direction.

● They play a significant role in the development of trends, as well as in the selection and
management of trades.

● A pivot high is a bar that has a higher high than the bar that came before it and the bar
that comes after it. At least in the very short term, the bar’s high represents the high-
water mark past which buyers were not able to push price, and can be considered a very
minor source of potential resistance.

● A pivot low is the same concept inverted: a bar with a lower low relative to both the
previous and the following bars.
● Price Peak

○ A peak forms after a prior advance when price stops making higher highs from
one bar to the next and makes a lower high.

○ Typically consists of 3 bars with the middle bar’s high above the highs of the bars
on the left and right hand side of it.

○ The high of the middle bar indicates the precise point where price stopped
rising and switched direction thereafter.
 ○ Peak only forms when a lower high as seen on candle bar 6 is fully formed.

○ Peak also referred to swing high, pivot high, rally high or even rally peak.

● Price Bottom

○ A bottom is formed after a decline when price stops making lower lows from one
bar to the next and goes on to make a higher low.

○ The low of the middle bar indicates the precise point price stopped falling
followed by a change in direction.
 ○

○ Bottom also referred to as swing low, pivot low, rally low, trough.

● Tweezer Tops & Bottoms

○ Occurs when price pivoting action is formed from more than 3 bars (left, middle
and right).

○ Tweezer Tops: Formed when the high of two or more consecutive bars are
exactly the same price, halting an initial price advance. So long as there are
lower highs on the bars each side of those consecutive, a peak is formed.

○ Tweezer Bottoms:
○ The higher lows on each side of the middle 3 candlesticks (with exact same lows)
indicates that a bottom has formed.
● ST relief rally within an IT downtrend

○ Stock did make higher highs and higher lows for a short period of time from
5th March - 8th March 2013 indicating a short-term uptrend.

○ But zooming out, the stock was in a clear intermediate-term downtrend, forming
lower peaks and lower bottoms.

○ Thus, the price advance that occurred from March 5 to 8 (3 days) was merely a
temporary relief rally i.e. a short-term uptrend within the longer downtrend.
Downtrend resumed after that relief rally!

○ A new 52-week high = The highest price reached in the past year.
 ● Price pivots are the Building Blocks of Trends

○ A series of peaks and bottoms will form on the chart as price moves up & down
in the general direction of the trend.

○ Price pivots also consist of the formation of classic chart patterns that tend to
either interrupt (continuation patterns) or reverse (reversal patterns) a trend.

○ Note the double bottom bullish reversal pattern that formed on the above chart,
with two prominent bottoms formed at approximately the same price level
(thereby making the pattern very recognizable).

○ Triangles or Trading ranges are typically formed from peaks and bottoms as
price swings back and forth across the pattern.

Role of Price Pivots in Trend Analysis

1. Determine direction of the trend. An uptrend consists of rising peaks and rising bottoms;
and a downtrend is formed from declining peaks and declining bottoms.

2. Drawing trendlines to identify the trend’s:

 a. Direction

b. Slope

c. Duration

3. Identify support and resistance levels that form within trends.

4. Recognize when the trend may be losing momentum. For e.g. a divergence is present or
price is unable to break through the prior peak (uptrend) or bottom (downtrend).

5. Determine when a trend may be changing direction (e.g., price breaks support or
resistance).

6. Defines the precise starting and ending points of a trend.

7. Used for calculating the amount of gain or loss during a trend, i.e. determine the
distance price traveled either in points or percentage (or both).

Trendlines

● Can be helpful for determining the direction, slope and length of trend.

● Can alert to a potential reversal of the trend when an important line is broken.

● A trendline is drawn touching the turning points of peaks or bottoms

● Resistance trendline

○ Downward sloping trendline drawn across and connecting the declining peaks
(1– 4), trapping the price action below the line.

● Support trendline

○ Upward sloping trendline is drawn across and connecting the rising bottoms
( 1– 3), trapping the price action above the trendline.
 ● Horizontal trendlines can also be drawn on charts to identify key support and
resistance levels formed by prior peaks and/or bottoms, and extended to the right edge
of the chart to identify when price is approaching those levels again.

External vs Internal Trendlines

● External trendline rests on the edges of the price pivot i.e. the highest point of the peak and the lowest

bottom.

● Internal trendline rests on the top and bottom bodies of the peaks and bottoms

○ The line can slice off the wicks/shadow(s) of a pivot but shouldn’t cut through the
body of a bar.

○ The shadows which are the thin vertical lines protruding from above and beneath
each candle bar represent the extreme prices or outliers for that period (where
there may be only a few trades executed)
● Both external and internal lines are valid, and the area between the two forms a zone of
support or resistance.

● General Rule: Price has to close away from the external line to consider it a valid
trendline break (especially when there is not much distance b/w both lines). This puts
price clearly outside that zone of support (up trendline) or resistance (down trendline).
Moving Averages

● They are trending indicators that are plotted over price, which help to:

(i) Remove some of the noise out of price movement

(ii) Smooth out fluctuations and distortions inherent in most trends

(iii) Draw attention to the primary direction of the trend.

● 20-period is a good moving average length to use for the purpose of determining the
direction of an intermediate-term or longer trend.

○ Fairly robust setting and works well on all timeframes.

● 20-MA will be rising most of the time during a strong upward move and falling most of
the time during a strong decline in price.

● When price moves sideways for a prolonged period of time, 20-period SMA will move
sideways or show a rolling motion until price begins to trend again.

● Lagging Indicator: The moving average will lag behind price so it doesn’t provide
precise timing signals for trend reversals.

● Daily Chart of AT&T shows all 3 scenarios

 ● Alternative way to use MAs would be to plot 2 short-term moving averages over price,
for e.g. a 10-period & 20-period moving average.

○ During an uptrend, the faster 10-period MA will rise and remain above the
slower 20-MA.

○ During a downtrend, the faster 10-MA will fall and remain below the slower 20-
MA

○ During a consolidation, the 2 MAs will flatten out or roll, causing them to cross
each other frequently (whipsaws) until price begins trending again.

Criteria for an Uptrend

● Conditions for charting an uptrend support line:

○ Upward price swings typically consist of primarily bullish candles.

○ Magnitude of upswings is usually greater than that of dips (pullbacks) that

follow. Otherwise, the uptrend could not continue.

○ There must be at least one new prominent rising bottom after the stock has
changed direction from a downtrend to an uptrend before a rising support
trendline can be drawn.

○ Trendline should touch (i) the bottom that was the reversal point of the prior
downtrend and (ii) a higher bottom (labeled B1 & B2 in the above chart)

○ The shift from downtrend to uptrend began off the December 2012 bottom
(labeled B1).

○ The rising bottoms (labeled B2 through B4) represent the upward shift. The
prominent peaks (labeled P1 through P4) are rising.
 ○ 20-SMA turned up and is rising.

○ Additionally, a support trendline can be drawn connecting the rising bottoms (an
internal trendline is illustrated). In fact, if desired, a parallel resistance trendline
could also be drawn across the rising peaks forming an ascending price channel.

● Note:

○ If price pulls back deeply enough, it may temporarily decline below the 20-SMA,
and will rise back above then the uptrend resumes.

○ Some cases a pullback will be deep enough for the 20-SMA to turn down
temporarily, but it will turn back up as the uptrend resumes.

○ There may not be one specific price pivot that marks the precise reversal point of
the prior downtrend, but rather there will often be some type of bottoming price
action (possible formation of a double bottom or a rounded/rectangular bottom)
followed by rising bottoms as seen below.
Criteria for a Downtrend

● Conditions during a Downtrend

○ Downward price swings typically consist of primarily bearish candles.

○ Magnitude of downswings usually greater than that of relief rallies (bounces)

that follow; Otherwise, the downtrend could not continue.
 ○ Must have at least one new prominent declining peak after the stock changes
direction from an uptrend to a downtrend before a declining resistance trendline
can be drawn.

○ Trendline should touch the peak that was the reversal point of the prior
uptrend and a lower peak.

○ The declining peaks (labeled P2 through P4) and declining bottoms (B1 through
B3) suggest price is in an intermediate-term downtrend.

○ The 20-period SMA turned from up to down as price reversed direction from the
bearish double top pattern that formed at the January and March 2013 highs.

○ A resistance trendline connects the declining peaks.

○ Note that the down trendline in Figure 2.15 does not quite touch the peak labeled
P2.

■ If the chart was viewed before the peak labeled P3 had formed, a
downtrend line would have initially connected P1 & P2.

■ It was however broken when P3 was formed but since price

immediately turned downward , the line had to be adjusted slightly
upward to touch that new peak P3.

○ As a trend evolves, the trendline may need to be adjusted and lengthened,

sometimes several times, in order to reflect the current slope and duration of the
trend until such time as that trend changes direction.

○ Sometimes there is more than one valid trendline. For example, prices may be
rising at a certain slope and then accelerate upward. That price action may
necessitate drawing two trend lines at different slopes.

● Note:

○ If price bounces high enough, it may temporarily rise above the declining 20-
SMA. It will move back below the MA once the downtrend resumes.

○ In some cases, prices will bounce strongly enough for the MA to turn up
temporarily.
 ○ The downward shift may occur along some type of topping action followed by
declining peaks such as the above chart where the second top (P1) of the double
top pattern was the starting point for the down trendline.

Criteria for Sideways Movement

● Referred to as consolidation or a trading range.

 ● In the chart, the uptrend was interrupted by consolidation (symmetrical triangle formed
by converging trendlines) from Nov 2011 to mid-Jan 2012.

● The uptrend was stalled again (Trading range formed by parallel horizontal lines
indicating the upper and lower boundaries of the trading range) during March & April
2012 as price moved sideways for several weeks.

2. Assessing Trend Duration

● 3 Distinct market trend durations according to Dow Theory: Long-term Trend,

Intermediate Trend & Short-term Trend.

Long-Term Trend
● Also called the Major or Primary Trend.

● Dow Theory suggests that a LT trend lasts up to 1 year or longer.

● Market practice to consider a trend that has been in force at least for 6 months or
longer to be Long-Term.

● Some long-term trends can go on for many years.

● Assume that the major trend is always in force until there is clear evidence to the
contrary.

● Rare to find a long-term trend being quite smooth and which experiences only brief
minor interruptions, in practice.

● Price often zigs and zags its way in the general direction of the primary trend.

● It is common for a move in the direction of the major trend to be followed by a notable
interruption of the trend as shown on the daily chart of the DJIA (15-month spanning
from March 2012 to June 2013) below:
● Interruptions of the LT trend may last from several days, several weeks or several
months in some cases.

○ They can be in the form of a correction where price moves against the LT trend,
or consolidation where price moves mostly sideways.

● During the time span shown (August 2012 to late June 2013) there were upward moves
and periods of consolidation, each lasting from several weeks to a few months.
 ● Note how the 20-period simple moving average flattened out or exhibited a rolling motion
during the consolidation phases.

● At the right edge of the chart, the index is experiencing a correction of the trend that has
lasted five weeks so far.

● However, if you look across the entirety of the chart, it is clear from the prominent rising
peaks and rising bottoms that the index is in a prolonged uptrend.

● This chart shows the zigzag movement that is common in the formation of major trends.

● At the right edge of the chart, the index is experiencing a correction of the trend that has
lasted five weeks so far.

● However, if you look across the entirety of the chart, it is clear from the prominent rising
peaks and rising bottoms that the index is in a prolonged uptrend. This chart shows the
zigzag movement that is common in the formation of major trends.

● The major trend is important to investors who have a long-term focus for their investment
portfolios.

● Although active traders direct their activities toward the short- or intermediate-term
trends, the long-term trend may have a considerable influence on which strategy they
trade.

Bull & Bear Markets

● The Major Trend will always show whether the financial instrument being analyzed (be
it a market average, currency, stock etc..) is in a Bull or Bear Market.

● Bull Market: Long-Term Uptrend

● Bear Market: Long-Term Downtrend

● However, sometimes a bull or bear market can also be identified solely by its
magnitude even if it has not been in force for a prolonged period of time. So not only just
the duration of the trend.

○ The Tokyo Nikkei Index crashed down over 20% during a period of 15 days
between May and June 2013.

○ Although the duration of the decline was not nearly enough to be considered as a
long-term downtrend, a decline of -20% is widely interpreted by market
pundits as the dividing line for entering a bear market.
 ○ Note the sharp selloff in the Nikkei bottomed out in mid-June and much of the
decline had been recovered by mid-July.

○ Behaved more like a market crash with a relatively quick recovery instead of
extending deeper into bear market territory.

Intermediate-Term Trend

● These trends string together to form most long-term trends.

● Also referred to as the Secondary trend or a Correction.

● Dual Roles of the Intermediate Trend within the Major Trend

○ Extension of the Trend: Price moves in the direction of the LT trend for an
intermediate period of time and serves to extend (lengthen) the major trend.
There may be few to several such movements during the lifecycle of a typical LT
trend.

○ Correction of the Trend: Price moves against the LT Trend for an intermediate
period of time, i.e. price retraces a portion of the prior intermediate-term move.
For prior IT upward move (Bull market correction) whereas for prior IT downward
move (bear market correction). There may be several of such corrective moves
during the lifespan of a typical LT Trend.

● Intermediate-Term Trends typically last from 1 to 6 months max

○ Most of the movements in the direction of the long-term trend tend to last longer
than those that correct the trend.
 ○ There are some cases where the movements that extend the major trend last for
a few weeks, but more often than not such movements last for a few months (can
be up to 4 or 6 months).

Intermediate-term Interruptions

● Intermediate-term corrections

○ Price retraces a portion of the intermediate upward move (bull market correction)
or downward (bear market correction).

○ The above chart shows an intermediate uptrend from June to September 2012
on the Dow, followed by a significant retracement (slightly more than two-thirds)
of that prior trend (Oct to mid November 2012).
● Intermediate-term consolidation

○ Price moves primarily sideways for an intermediate-term period of time.

○ May stall a trend’s movement from a few weeks to several months.

● Corrections and consolidations occur during a long-term trend because the moves
that extend it get exhausted on an intermediate-term basis.

○ The market/stock becomes overbought (uptrend) or oversold (downtrend).

○ These moves allow the trend to rest and serve to alleviate the prior overbought or
oversold condition.

○ After which, price is then allowed to move again for a while in the direction of
the major trend until it becomes overextended again.

Formation of an IT Trend

● An intermediate-term trend may be strung together by a series of relatively short price

swings. Such short directional moves are separated by brief interruptions of the
intermediate-term trend.
 ○ A several-week period that formed just one intermediate-term upward leg of
the bull market in the index.

○ Uptrend from mid-Nov 2012 to around mid-Feb 2013 consisted of upward swings
separated by pullbacks against the prior upward swing and a sideways move
(minor consolidation).

○ Downward swings that have a more steeper slope can be considered as ST

pullbacks.

● Higher chance of having a smooth IT trend than a LT one due to shorter time span for
the former.

● However due to the presence of swing traders in the market taking profits after
short-term price swings, most IT trends will develop in a zigzag pattern strung together
by ST moves.

Short-term Trend

● Also called a Minor Trend or a Swing

● The average ST price swing typically lasts from a few days to 2 weeks, seldom longer
than 3 weeks.

○ General rule: Tend to last from 3 to 5 daily bars before encountering a brief
pause.

○ Some instances a price swing lasts longer than average, and there will be shorter
than average price swings as well.

● LT Trend provides a big-picture view of the market action, while IT Trend reveals the
movements within the major trend.

● ST Trends are ***Important for swing trading***

● ST price swings are the building blocks of most intermediate-term trends

● A short-term trend can move in the direction of the intermediate-term trend (extending it),
or it can move against the trend (retracing a portion of it).

● Dip / Pullback: When price moves against an intermediate-term uptrend.

● Bounce / Relief Rallies: When price moves against an intermediate-term downtrend.

Can be referred to as a short-covering rally since bearish traders covering their positions
can fuel a rally.

● ST trends get quickly exhausted.

● During the intermediate-length uptrend, the short-term upswings were stronger than the
pullbacks and periods of consolidation, allowing the uptrend to develop.

● Likewise, the bounces during the intermediate-length decline were minimal enough to
allow the downtrend to continue.
Rapid Price Moves in the Short-Term

● Occurs when price moves a great distance in a short-period of time (spanning from a
few days to a few weeks)

● A % move that equals to the distance covered during an IT trend or even a LT

Trend.

● May see a smooth, relatively uninterrupted price run.

● Difficult to draw a trendline across such a steep trend since there may not be any
prominent price pivots to connect the line since there will only be brief pauses
interrupting the trend instead of countertrend moves or sideways movements.

○ Charting a trendline on such a steep slope would cause it to cut through the
bodies of one or more price bars.

○ Thereby making it an invalid line and more prone to false breaks.

Parabolic Rise in the ST

● When a stock or index’s price makes a rapid rise (a significant % increase) in a

relatively short period of time.

● Such moves are typically spurred by rumor or news & can be exacerbated by ST traders
exploiting the opportunity.
● A fast steep rise occurred on the daily chart of China DangDang Inc, with a gain of 199%
from the April 2013 Low to the June High.

● It looks as if the surge in price will never stop rising but a vertical rise can’t be sustained
for a long period of time.

○ Such a swift move up creates a severely overbought condition that must at some
point be alleviation of the initial buying pressure.

● Price retraced nearly 50% of the parabolic move in only 4 days vs previous upward
move of a number of weeks

○ Selloff accelerates as layers of protective sell stops are triggered to lock in profits
or losses.

○ Hence, a retracement move can be sharp and fast and may result in a significant
decline.

● What to do when holding a long position in a stock that makes a rapid ascent:
 ○ Proactively exit the entire position (Selling into strength) upon the emergence
of any indication of a potential reversal to avoid severe downward pressures from
exiting with many other participants in a selloff.

○ Exiting part of the position to lock in some of the profits to reduce exposure to
a sharp selloff. Carefully monitor the protective stop loss order on the balance of
the position.

● Volatility often rises dramatically as the stock price accelerates.

● Breakdown from a vertical rise may result in:

(i) Pump & Dump scenario: Complete reversal of that move

(ii) Passing of initial hype: Partial retracement of the prior up move and
subsequent rise again at a more sustainable slope.

Rapid Decline

● Stocks have been observed to typically fall much faster than they rise.

● This becomes very obvious when the broad market declines sharply & a number of

stocks sell off quickly.

● May occur due to rumor or the release of news.

● A rapid decline may also occur after price has made a prior sharp advance i.e. parabolic

rise.
● Above chart shows a quick 67% decline on the daily chart of Infinity

Pharmaceuticals Inc (INFI)

● A price advance that took almost 5 months from Nov 2012 through March 2013 was

wiped out in about 2 months!

Starting & End point of Trends

● Only easy to spot the precise start & end points after the trend has ended, while
harder to determine the end point while a trend is still in force.
Determining a Trend’s Progress

● After identifying the starting & ending points of a trend regardless of it being LT, IT or ST,
one can determine the distance price moved during that trend, either in points or as a
percentage move.

● One should measure the distance of a trend’s rise or decline by measuring from specific
closing highs (Closing price of the highest peak/pivot high bar) and closing lows
(Closing price of the lowest bottom/pivot low bar).

● To get % decline of the correction on the above chart, use the 2 following values:

○ Closing high of the highest peak prior to the start of the correction = $43.32 on
Feb 14, 2013.

○ Closing low of the lowest bottom marking the end of the correction = $37.21 on
April 19, 2013.

○ % move = (43.32 - 37.21)/43.22 = 14.1% decline

 ● Monitoring a trend’s progress while it’s in force:

○ Can be used to compare the move, to date, of a stock or index to that of another
stock or index or a list of tickers.

○ Useful for seeing which sector(s) or group(s) of stocks that are

out/underperforming the index within its current up/downtrend and which sector is
leading/lagging compared to the rest during a certain period of time e.g. YTD,
MTD etc.

Drawing Long-term Trendlines

● Starts at the price pivot that marked the reversal of the prior major trend.

● When analyzing a trend as it evolves from the right edge of the chart during the early
stages of a LT trend, it won’t actually be a long-trend yet

○ LT Trend only applies when it has been in force for at least 6 months!

● Thus, the first trendline drawn on what ultimately becomes a long-term trend will **
typically be an intermediate-length trendline **

● That particular IT trendline may be broken during the first significant correction or
prolonged consolidation which forms within the new major trend.
● Trendline 1:

○ First several weeks of this new LT trend in UCBI was actually an IT upward move
against the prior downtrend.

○ Trendline drawn across all prominent rising bottoms.

● Trendline 2:

○ Price consolidates initially for 3 months, breaking IT uptrend line 1.

○ Once the consolidation ended and price resumed the up trendline, new uptrend
line 2 was drawn representing the new length & slope of the trend.

○ Line 2 was continuously extended upward until it was broken during a correction
of the uptrend.

● Trendline 3:

○ Drawn once the correction ended and price began to move up higher again.

○ This trendline now correctly reflects a long-term uptrend, starting from the major
reversal point & will be continuously extended upward until it is broken at some
point in the future.
● If the major trend exceeds about a year in length, it would be easier to shift up to a
weekly chart to gain a fuller perspective of the duration & slope of the trend.

● The peaks and bottoms that identify the direction of the LT Trend on the weekly
timeframe are the significant turning points within the trend.

● Major trends are joined together by IT trends, corrections and periods of consolidation.

● Hence in a major uptrend, the rising peaks are the tops of the IT uptrends within the
major trend, while the rising bottoms are the lows of the IT (i) corrections (ii) ends
of consolidations periods.

● The bottoms used to connect the up trendline are the lows of significant corrections
that have occurred during the past several years within the bull market of SPDR Select
Sector Utilities ETF (XLU).

● As the long-term uptrend continues to evolve, the long-term trendline will need to be
continually extended up and to the right to reflect the current length of the trend.
 ● Additionally, it may need to be adjusted upward or downward periodically to reflect
changes to the slope of the trend as additional extension moves and corrections or
consolidation phases occur.

● For LT downtrends, the first leg down within a new major trend will appear to be a bull
market correction and the first down trendline drawn will be an Intermediate-term line.

● It will be adjusted & extended (or redrawn) as the downtrend carries on with its decline,
eventually forming a long-term trendline.

Intermediate-Term Trendlines

● IT trends are strung together by ST price movements.

● An IT up trendline begins at the lowest price pivot of that trend at point 1.

● The rising bottoms used for connecting the support trendline are the prominent price
pivots (pullbacks) and periods of minor consolidation formed during the IT trend
from point 2 to point 5.
● The tighter IT trendline was more indicative of the recent price action and was broken
quickly as price pulled back.

● Bearish Double Top formed after price broke below the trendline, while it took a
significant retracement before the looser trendline was broken.

● Note:

○ When a trend accelerates along a tighter trendline, even a pullback or a shift to a

consolidation can break the tight line.

○ However, it may not necessarily signal a correction that’s coming but just
due to (i) a deeper than normal pullback (ii) enough sideways movement to break
it.

○ Price might penetrate the line a bit and then move again in the direction of the IT
trend, so just adjust the trendline to the new slope and length of the trend
when that happens.

● For the IT downtrend, the declining peaks used to connect the downward-sloping
resistance trendline are the tops of the swing highs (bounces) or the ends of minor
consolidations formed within the downtrend.
 ● On the daily chart of U.S. Steel Corp. (X) in Figure 3.19, the tighter trendline represents
the acceleration of the downtrend.

● Both lines were broken during May 2013. In June, price tested the May low setting up a
potential bullish double bottom pattern.

Short-Term Trendlines

● May not be possible to draw a trendline since it requires at least 2 price pivots for the
line to be drawn , i.e. 2 rising bottoms to map an upward trendline & 2 declining peaks
to map a downward trendline.

● The above chart depicts a short-term uptrend with only one pivot at the bottom of the
upswing, with price forming higher lows from one bar to the next for several days (bars 1
– 6) and then reversing direction, essentially ending the upswing without having formed
a higher bottom.
● Swing traders will typically attempt to profit on the short-term price swings & exit
before price reverses direction and takes back part, if not all, of those profits. Hence,
they may utilize ST trendlines when they can be drawn.

● A break of a ST trendline indicates the upswing or downswing may be ending.

● Alternatively, a trader can make use of an intraday chart (due to having more data points
& more price pivots being visible) if they wish to monitor a trendline on a ST trend which
doesn’t have 2 price pivots on the daily chart.

● The above shows 2 minor price pivots formed within the minor uptrend, resulting in a
tight trendline which can be easily broken quickly, often due to a minor pullback or a
period of brief consolidation.
A Swing on a Higher Time frame is a trend on a lower Time frame

● The above shows the number of bars on each lower time frame within a trading day.

● An upward price swing of 6 bars (short-term trend) on the daily chart would be an
upward trend of 42 bars (6 x7) on the hourly chart (intermediate-term trend) and an
upward trend of 156 bars (6 x 26) on the 15-min chart (long-term trend).
● General rules on timeframes:

○ A swing movement on a higher timeframe represents a trend on a lower

timeframe.
 ○ The end of an upswing (swing high) on one time frame is the reversal of an
intermediate- or long-term uptrend on lower time frames.

○ The end of a pullback (swing low) during an uptrend on one time frame is the
reversal after a correction on lower time frames.

3. Assessing Trend Interruptions

● Categories of interruptions within a trend can be defined by:

○ Duration of the consolidation

○ Magnitude of the interruption

○ It’s role in a trend’s development

○ The screening method used to find the formation if utilizing it for trading setups.

○ The techniques used to manage trades that are impacted by, or based on, the
formation.

● The above are common occurrences on all time frames.

 ● Minor or larger trend interruptions are separated based on their (i) duration, (ii)
magnitude, (iii) the role they play in the development of an intermediate- or long-term
trend.

● Trends tend to get exhausted, thereby forming such consolidation patterns.

● For a Short-Term Trend

○ After a few days of directional movement, it tends to get overbought (upward

swing) or oversold (downward swing) on a short-term basis.

○ This may cause a minor interruption of the Intermediate-term trend to occur.

○ Usually it doesn't take much to alleviate the overextended condition, often

undergoing a minor pullback or period of brief consolidation, after which the IT
trend resumes its course.

● For an Intermediate Trend

○ After several weeks to a few months of trending up or down, it tends to get

overbought or oversold on an intermediate-term basis.

○ Often takes a more significant countertrend move (correction) or a longer

period of consolidation to alleviate the overextension in price, thereby possibly
causing a larger interruption in the major trend to occur.

(i) Minor Trend Interruptions

● Can take the form of a quick pause, a small base (period of minor consolidation), or
move against the trend (pullback or bounce)

● Occur during intermediate-length trends (at least 4 weeks to less than 6 months) i.e.
in-between short-term price swings.

● Are healthy in the development of a trend by allowing it to rest & letting the stock/index
consolidate losses from the prior downtrend & consolidate gains from the prior uptrend.
● Short-term Swing Trader Tactics:

○ Can choose to hold off from entering a position into stock when its price may
have been overbought (chasing an upward swing) after a quick run-up.

○ Wait for any pullbacks or consolidation in price during the next couple of days to
provide a safer entry paired with a relatively tight stop-loss to achieve a better
risk-to-reward opportunity.

● Long-Term Investor Tactics for core (Long-Term) positions:

○ Wait for pullback or consolidations to slowly make small purchases to build a new
position on a stock that appears to have plenty of room to run.

○ Add on shares to existing core positions by scaling into a trade i.e. opening a
trade with a relatively small position and, as the trend shows more promise of
continuing, adding more shares to increase the total position size.

○ Lock & Reload: Add back shares to a core position that were previously sold
(ongoing long) or covered (ongoing short) to lock in profits.
Pauses (Consolidation days) in a Swing

● Usually takes 1 to 3 days to form before the prior price swing continues.

● Act as minor speed bumps in between short-term price swings that slow the trend
temporarily.

● Pause after a short-term upward swing:

○ Typical upswing consists of primarily bullish candlesticks, with a longer than

average bodied candlestick preceding a brief pause in the ST trend

○ Distinctive shift in the size of the consolidation day candlestick bodies (becomes
narrower) for a brief period, typically 1 - 3 days at most. Any longer would be
considered a base formation.

○ Price stops making higher closes & sometimes higher highs, and closes
unchanged or relatively near each other during the consolidation day(s).

○ Price may even close a bit lower into the prior bar’s range, but shouldn’t be a
significant decline orelse it may be considered a pullback.

○ Price typically remains above the ST moving averages i.e. 10 & 20-period SMAs

○ Another swing up follows the consolidation day(s).

○ Selling by swing traders locking in their profits is entirely absorbed by bullish

traders which prevents a deeper pullback or longer period of sideways
movement.
○ Price pivot may form on consolidation day candles and can act as a support level
to place stop losses for trades:

○
 ○

● Pause after a short-term down swing:

○ Typical downswing consists of primarily bearish candles, with some of them

having average length or longer bodies.

○ After a swing down, price may pause, forming a small-bodied bar or a Doji for a
day or two.
○

■ As shown in Fig 4.5, the pause can be found in one continuous price
swing, with such short-term moves lasting a few weeks (seldom longer
than 3 weeks). In this case price typically won’t form a new pivot when
pausing.

■ In other cases, the pause may form in a way that has the appearance of
separating two price swings (Figure 4.6), and a minor pivot may form.
 ■ When price pauses during a downtrend, especially if the pause includes a
bullish candle (Figure 4.6), some swing traders will cover their short
positions fearing that a bounce may be starting.

■ The above chart shows a series of unconfirmed or failed bullish

candlestick patterns.

○ Note:

■ Candlestick signals don’t work 100% of the time!

■ Candlestick signals are only effective when used in context of the

surrounding chartscape.

■ Wait for confirmation of the candlestick signal to avoid getting on the

wrong side of a price move!

■ Always be aware of the tone of the broad market since it may influence
the effectiveness of certain patterns during certain times. Stock in fig
4.7 was falling while the Dow was experiencing a correction during the
same period.
Bases (Minor consolidation)

● A price base or basing occurs when price moves sideways for > 3 consolidation
days or daily candlestick bars & maximum up to 3 weeks.

● Shallow bases provide a setup for a potential trade e.g. going long if price breaks out
above the top of the base or add shares into an existing core position.

● Can take a more earlier entry by entering into a position while price is still
consolidating in anticipation of a breakout move.

○ This leads to a greater payoff since a stop loss can be placed fairly close to the
entry price.

○ Increases the odds of the price moving against your trade, so better to do so only
when the broad market is quite favorable for an upside break i.e. during
early-to-mid stage of an up leg in a bull market, rather than when the
intermediate-term uptrend is overbought and vulnerable to a correction.

○ Base 2 shows a tight consolidation with little depth and shorter duration while
Base 1 had slightly more depth and lasted longer.
● Note: A larger trading range typically has more depth to it and often lasts significantly
longer.

●
Pullbacks in an Uptrend

● Pullbacks are short-term dips/declines within an ongoing intermediate-term uptrend,

retracing a portion of the prior upswing.

● As price turns back up after pulling back, that pivoting action leaves a level of support
below price (the rising bottoms in Figure 4.10).

● Pullbacks are common occurrences within an uptrend.

● They’re formed when ST traders take profits on ST moves & the selling pressure causes
prices to dip.

● Pullbacks alleviates the prior ST overbought condition and is often followed by another
swing up in the direction of the prevailing trend as bullish traders buy the dips.
 ● Price may retrace about ⅓ or ⅔ of the prior upward swing and sometimes even the
entire upswing.

● The decline may stop at or near an area of support such as a prior price pivot or a short-
term moving average (e.g. 20-SMA), while a deeper pullback may reach the 50-period
moving average.

● Volume may taper off during the pullback, a typical indication of profit taking by ST
traders rather than a major selloff where volume may be heavier. However, there are
cases where there’s fairly strong volume during the dip as weaker hand traders get
shaken out.

● A pullback within an uptrend is a price setup that requires a specific entry trigger to
go long i.e. a signal that price is done falling such as a break above the prior bar’s high
or a break above a prominent resistance level visible on an intraday time frame.

● When price turns up out of a pullback on the daily chart, it is a trend reversal occurring
on the lower time frames.

Bounces in a Downtrend

● During a downtrend, price may turn up against the trend & retrace a portion or
sometimes all of the prior down swing.
 ● It is a short-term rise within an intermediate-term downtrend and is often followed by
another move down.

● Termed a minor reversal, bounce, rally, relief rally or a short-covering rally.

● After a downward swing, traders may cover part, or all, of their short positions fueling a
bounce. Some bottom fishers may enter long positions, adding to the buying pressure.

● Price may bounce from one to several times during an intermediate-term downtrend.

● A bounce is a price setup that may offer an opportunity to initiate a short position, or to
add shares to an existing short position.

Flags & Pennants

● Flags and Pennants are trend continuation patterns that serve as minor interruptions
of a trend.

● Flags look like a small rectangle.

● Pennants look like a small triangle.

● Both patterns are preceded by a sharp upward move ( bullish flag or pennant) or a sharp
decline (bearish flag or pennant), known as a pole.

● Flag/Pennant can be formed by (i) a pullback or a bounce if it tilts against the up or down
trend or (ii) a base if it moves sideways.
○ In Fig 4.12, the flag tilts against the prior downtrend & the short upward sloping
line identifies the lower boundary of the flag.

○ The horizontal dotted lines identify the length of the pole.

○ Thus, a breakdown through that upward sloping support line may be used as a
sell signal for shorting the pattern; or a trader may wait for price to break below
the swing low at the bottom of the pole.

○ The entry chosen may depend on the intended duration of trade (e.g., a swing
versus a core trade), and/or whether the trader chooses a more assertive entry
versus one that is more conservative.

○ In the case of selling short, the entry method chosen may have an impact on the
trader’s ability to borrow the needed shares.
●

○ In Fig 4.13, the short downward sloping support line is used to identify the
breakout point for an entry to go long.

○ A more conservative trader may wait for price to break above the peak at the top
of the pole.

○ The pole is identified by the 2 dotted horizontal lines.

Reversion to the Mean

● Mean reversion refers to the tendency for price to eventually move back towards the
average.

● A general rule is that price doesn’t deviate too far from the average, and when it does, it
becomes prone to a change in direction.

● Since swing traders focus closely on price action & take profits after a directional move,
their actions often force prices back toward their average.

● Proximity of price to the 20-Period SMA (A strong average):

○ When price deviates too far from the 20 SMA, it may become exhausted or
overextended (overbought/oversold), on a short-term basis.

○ The probability of a temp reversal in price direction toward the avg rises too.

○ Overextension in price can be alleviated by (i) price moving primarily sideways (a

base), allowing the average to catch up with it & narrowing the distance or (ii)
price turning back toward the average via a pullback in an uptrend or a bounce in
a downtrend.
● Bollinger Bands & 20-SMA:

○ The upper & lower bands are plotted 2 Stand devs away from the 20-period SMA
and have a tendency to contain most of the price movement.

○ Price may move toward the upper or lower band or beyond either sometimes, but
has typically gravitated back toward the 20-period SMA in the center.

○ Price will always need to stabilize after a price swing.

● Important: The 20 SMA tends to be a good gauge to depict price moving away from the
average and then dipping back or moving sideways to consolidate those gains.

● Price may turn again before reaching the MA (support level), or it may overshoot it
before changing direction.

● Note: Without the minor interruptions occurring within a trend, price would move too
quickly to extreme & unsustainable levels.

● Trade execution: Minor interruptions also provide opportunities to get aboard a trending
stock at a lower-risk entry point, instead of chasing its price & entering into it at price
levels that are prone to setbacks.
Dealing with Probabilistic outcomes

● Probability is the likelihood but not the certainty of something happening or being true.

● Probability provides a gauge of determining risk and reward.

● Traders test out price set-ups and strategies to determine the probability of taking
successful trades i.e. always put the odds of winning on their side.

● Traders study price action, volume, the impact of volatility to ascertain which set-ups
have a high or low chance of occurring, after which they make trade selection, risk
management and trade execution decisions accordingly.

● If a swing trader holds a long position in a stock and does not wish to hold the position
through a potential pullback, he should be on the alert for signs of weakness suggesting
it may be time to exit the position.

● However, there is the chance that, rather than turning against the trend, price may just
pause briefly. Therefore, he may choose to take partial profits, allowing the remainder of
his profits to run should the price push forward again rather than retracing the prior
move.

● This is a calculated risk the trader takes; and he also makes sure to protect the
remaining capital still invested.

● If a trader is looking for an opportunity to enter a position, but the stock has caught air,
chances are good that the price will turn back or move sideways soon rather than
continuing to move away from the average. Thus, he may monitor the price action
watching for a better entry opportunity.

(ii) Major Trend Interruptions

● Larger interruptions are more significant in their magnitude and/or duration.

● Such events separate the intermediate-length moves that occur in the direction of the
major trend.
Moving Averages

● Moving averages are lagging trending indicators.

● Commonly used averages: 50-, 100- and 200-period

● Once an uptrend has been in force for a period of time, those MAs will be rising and
stacked on top of each other.

● During a pro-longed downtrend, they’ll cross below each other and be declining.

● 50-, 100- and 200-periods are widely used on the daily chart due to them being approx
equivalent to the 10-, 20- and 40-week moving averages that are frequently used by
chartists that monitor weekly charts. (So can just monitor the 50d/100d/200d avgs
without having to change the time frame)

● During a minor correction of a trend, price may find support (correction of uptrend) or
resistance (correction of a downtrend) at the 50-period SMA.

● During a deeper correction, monitor how price responds when it tests the 100- and 200-
period SMAs.

● Note: The 50- and 200-period moving averages are more commonly referenced than the
100-day. However, the 100-day approximates the 20-week, which is closely watched on
that time frame, so it should not be disregarded.
Correction of an Uptrend (Bull market correction)

● Occurs in an uptrending market when price retraces a significant portion of the prior
intermediate-term upward move.

● After a correction, price gets oversold and is often followed by another intermediate-term
move in the direction of the major trend.

● Minimum retracement: Typically about ⅓ of the prior IT trend. A retracement of ½ of

the prior trend is common.

● Maximum retracement: Is about ⅔ of the prior trend. Any retracement beyond ⅔

implies it’ll be less likely that the major trend will resume & a more significant reversal is
under way.

● What may occur during an uptrend correction:

○ Price closing below one or more ST MAs such as 20-period, which it had
previously remained above.

○ Price may reverse direction deep enough to test or break intermediate- & longer-
term MAs such as 50-, 200- and 200-period.

○ The faster 10-MA may cross below the slower 20-period SMA.

○ A prominent intermediate-length trendline is often broken.

○ Price may retrace to a well-known Fibonacci level such as 38%, 50% or 62%.

○ A protective stop loss order on an open core position may be triggered.

○ As price turns back up after a correction, it leaves a prominent and important

support level below!
●

○ Base 1: After an upward swing that began in mid-Jan 2013, price moved
primarily sideways for 2 weeks.

○ Pullback 1: Price broke out above the base on Feb 7 2013, starting another
upward move, which was followed by a minor dip in mid-Feb.

○ Pause: The next swing up was a long candle, followed by a couple of

consolidation days.

○ PB 2: There was more upside movement as the IT uptrend progressed on. Price
then pulled back for 4 days in early March 2013.

○ Base 2: After a prior upward swing, a small base formed in mid-April.

○ Correction: The next trend interruption was a sharp or rapid decline (parabolic
price move) from April 25 to 30. Although it lasted a few days, it declined about
just over 20% within that short-span of time.

○ Note: During the minor interruptions, price held above the 20-period SMA
except for PB3 where it closed marginally below it while during the deeper
correction, price broke below the 20- & 50-period SMAs.
 ● A correction doesn’t imply that the long-term trend has ended but means price had run
up /fallen far enough in the direction of the major trend to become overbought
(uptrend) or oversold (downtrend).

● Recommended to look for a re-entry opportunity when the stock gets overextended in
the primary trend’s direction during a correction.

Correction of a Downtrend (Bear market Rally)

● A downtrend correction occurs when price retraces a significant portion of the prior
Intermediate-Length decline as shown below:

○ An intermediate-term decline happened from Feb 4 through April 19, 2013.

○ This is followed by a nearly 3-week correction, causing price to retrace just over
50% of the prior downtrend & stopping at the 100-Period SMA.
Fibonacci Numbers

● Fibonacci grid is a method for measuring price retracements within a trend.

● Used to gauge the potential depth of a correction.

● Common retracement levels are 38, 50 and 62 percent of the previous up or down trend.

● 38% and 62% retracements correspond fairly closely to the ⅓ and ⅔ retracements.

● Prone to subjectivity since the starting and ending points of the grid can differ from one
trader to the next.

● Plotting retracement of an Uptrend: Start the grid at the lowest point (lowest low) of
the trend and drag it up to the highest point (highest high) of the uptrend.

● Plotting retracement of a Downtrend: Start the grid at the highest point (highest high)
of the trend & drag it down to the lowest point (lowest low) of the downtrend.

● Log scale chart: Distance between each horizontal gridline is an equal % increment.

● Arithmetic scale chart: Shows equal increments in points between each horizontal grid
line.
● Using Log scaled charts vs Arithmetic scaled charts:

○ On one hand, arithmetic scale chart can help to better visualize the depth of
retracement from a correction of an IT trend compared to a log scale chart:

● On the other hand, log charts should be used for & show more consistent swings
throughout long-term charts spanning > 2 years of data or shorter-term charts in which a
security price increased in value by >100%.
 ● On a very long-term chart, linearly/arithmetic scaled charts will often make price changes
at lower price levels so small that they disappear and they are completely dwarfed by
price changes that happened at higher levels.

● The linear/arithmetic scale also magnifies the importance of those higher-level price
changes, making them seem more violent and significant than they actually were.

● During a pullback (uptrend) or bounce (downtrend), price may retrace from one-third
to two-thirds of the prior short-term upward or downward swing, respectively.

Consolidation Phases

● Happens when price moves primarily sideways (whipsawing) & makes no progress in
the direction of the major trend.

● Represent periods of indecision and are often accompanied by low volatility.

● During periods of consolidation, there’s an equilibrium b/w the forces of supply and
demand where neither bulls nor bears can exert enough pressure to break price
out of the channel.

● Also termed congestion, trading range or horizontal channel.

● Duration: Consolidations can interrupt the major trend from > 3 weeks to months or
years.

● Their presence creates support and resistance levels, sometimes major ones. Price will
likely encounter those areas again

○ For example, during a future correction, or even later when the major trend
reverses course (from a bull to a bear market, or vice versa)

● What occurs during a period of consolidation:

○ 2 or more peaks may form at or near the same price level, creating a ceiling
above price.

○ 2 or more bottoms may form at or near the same price level, creating a floor
below price.
○ The ceilings and floors define the upper and lower boundaries of the trading
range in Fig. 4.22 and 4.33.

○ If the channel lines are converging rather than parallel, then price may be
trapped in a triangle as per Fig 4.2’s ascending triangle. Each price swing
becomes shallower than the previous price swing.

○ The 20-period SMA will stop trending and flatten out or move sideways in a
rolling motion as shown in Fig 4.21 to 4.23.
○ If viewing 2 ST MAs (10- & 20-periods), they may intertwine with each other a
couple of times during the period of consolidation.

○ Volume may taper off noticeably during the consolidation phase as in Fig 4.2, but
this may not always be the case. Use a 30-Day SMA of volume to see if
volume is above or below average.
 ○ The Bollinger Squeeze: Bollinger bands, using 20-period & 2 Stand Dev
settings, will usually begin to tighten as seen in the daily chart of Fig 4.21.

● Double/Triple Tops: 2 or 3 nearly parallel peaks (after uptrends)

● Double/Triple Bottoms: 2 or 3 nearly parallel bottoms (after downtrends)

● Note:

○ Reversal pattern is not validated until it’s confirmed by price breaking down
(top reversal pattern) or breaking out (bottom reversal pattern) beyond a
specific barrier.

○ Although trading ranges & triangles are more significant continuation patterns &
price often resumes the prior trend after consolidation, there will still be times
where price reverses course instead due to the perception of a top reversal
(uptrend) or bottom reversal (downtrend) being formed.

● Correction transitions into Consolidation:

○ From mid-Sept to early Oct 2012, price declined almost 12%, retracing a portion
of the intermediate-term uptrend.

○ On the next swing up, price found resistance at the peak that marked the top of
the prior intermediate-term uptrend.
○ After which price moved back and forth in a relatively wide trading range, before
gapping above its ceiling and resuming the major trend.
Triangles (Tug of War)

● Ascending Triangle: Rising bottoms + Double or more Tops around same level

○ Buyers maintain a level of strength while selling pressure continues to weaken so

buyers have the upper hand.

○ Each time sellers push prices down, bulls step in and push shares back.

○ Every decline stops at a higher level than the previous decline — a sign that
bears are unable to push prices lower.

○ Eventually, buyer strength overwhelms the sellers, and the security breaks
upward, usually on heavy volume.
 ○ Minimum price movement from breakout = vertical distance b/w the breakout
resistance level and the lower upward sloping support line.

● Descending Triangle: Declining Peaks + Double or more bottoms around same level

○ Sellers maintain a level of strength while buying pressure continues to weaken,

thus giving sellers the upper hand.

○ Shown as prices falling to a certain level and subsequent rallies ending at lower
peaks or swing highs.

○ Eventually, the buying pressure dries up, and prices break downward.

○ Minimum price movement from breakdown = vertical distance b/w the breakout
support level and the upper downward sloping resistance line.

● Symmetrical Triangle: Series of lower peaks + higher bottoms

○ Represent a stalemate b/w buyers and sellers where both pressures are evenly
matched.

○ Each rally ends at a lower peak than the previous rally, whereas each decline
ends at a higher trough than the previous decline.

○ So you can't really tell whether buyers or sellers will eventually overwhelm each
other.

○ Generally expect the outcome of this formation to be a continuation in the same

direction of the prior trend.

○ Minimum price movement from breakout = vertical distance between the

breakout level to the corresponding bottom/upper line of the triangle.

Trend Reversals

● A trend reversal is not technically underway until price has retraced at least ⅔ of the
prior trend.
 ● However, a reversal or trend reversal may generically mean a shift from up to down, or
vice versa.

● Although price often does change direction, at least temporarily, when a visible
support or resistance area is tested, that is not the only factor contributing to
reversals!

● Other factors leading to a reversal in direction include:

○ The broad market or stock’s sector/industry group turning up and down, pulling
that particular stock with it.

○ The stock or market becomes overbought (uptrend) or oversold (down-trend) and

traders take profits that were accrued in the prior move. Their cumulative actions
caused a reversal.

○ News was released that caused a stock, or the market, to reverse direction.

4. Early Trend Reversal Warnings

● The warnings above may occur toward the end of an intermediate-length trend (>1
month), hence, should be monitored on the daily chart.

● Applicable to both individual stocks and broad market indices.

● Last leg of a bull or bear market is typically an intermediate-length move within the major
trend, so one or more of the above warnings may appear at the end of a LT trend.
 ● Since the final top or bottom of a bull or bear market is tested multiple times before a
reversal begins in earnest, these warnings may occur as part of a larger topping or
bottoming process.

● If monitoring the long-term trend on a weekly chart, you may see these trend-ending
warnings appear on that time frame.

● Some of the warnings listed in Table 5.1 cannot be applied to short-term trends since
many short-term trends would not last long enough to generate the criteria
needed for those warnings.

● Specific warning (Later trend reversal) signals that may occur prior to a short-term
trend changing direction.

Climax Move

● A climax move is strong enough to potentially alter the direction of a long or strong
up/down trend.

● They signal potential exhaustion by buyers (uptrend) or sellers (downtrend).

● Blow Off top: Climax move that occurs at the end of an uptrend.

● Capitulation: Climax move that occurs at the end of a downtrend.

● The initial move following a climax event may be fast and sharp.

● Periodically a major trend reversal will occur from such an event; or a climax move may
mark the start of a longer topping or bottoming process.

Key Reversal (A climax move)

● Negative (Bearish) Key reversal: Price gaps up at open to a new high in an

overbought stock or market. Price then reverses direction and closes near or below the
previous day’s close accompanied by heavy volume.
● Positive (Bullish) Key Reversal: Price gaps down at open to a new low in an oversold
stock or market. Price then reverses direction and closes near or above the previous
day’s close with heavy volume.
 ● The more longer the bar and the heavier the volume, the more significant the reversal
signal.

● Note: Price doesn’t necessarily have to completely engulf the prior day’s range (from
high to low) but may appear as an Engulfing pattern.

Exhaustion Gap

● Happens when price has been trending and suddenly gaps up or down on heavy volume
as a sign of the final push of buying (in an uptrend) or selling (in a downtrend) pressure
as it peters out.

● This is then followed by price reversing back into the gap in the following days.

● Bullish sign: Opening of exhaustion gap in a downtrend doesn’t provide resistance

when tested and price closes above it.
 ●

● Bearish sign in uptrend: Opening of exhaustion gap in an uptrend doesn’t provide

support when tested and price closes below it.

● Note: A gap to a significant ceiling (major resistance level) or floor (major support level)
is often followed by an immediate reversal.

Divergence

● Checks if a trend is losing momentum.

● Occurs when an indicator loses momentum before it’s reflected in the price action.

● Common indicators used are MACD, RSI & OBV

● Notes:

○ Look for divergence only when price has been trending up (negative
divergence) or trending down (positive divergence).

○ Look for divergence during intermediate-term (daily charts) or LT trends (weekly

charts)
○ Can take several weeks or months for peaks or bottoms to form on the weekly
chart so don’t have to check daily.

○ Forgo divergence check while price is in a prolonged period of sideways

movement i.e. consolidation. Just means that the trend has changed to moving
range bound from up or down.

○ There must be a pivot present to check for divergence i.e. don’t check for
negative divergence when price is still forming higher highs from one day to the
next. Wait for the price to pivot and then check for divergence.

○ There may be 2 or more divergences that occur during the trend before it actually
changes direction.

○ If a reversal does occur, it typically starts fairly soon after the divergence signal
(usually within one to a few days).

○ A divergence is stronger if it occurs from an overbought (negative divergence) or

oversold (positive divergence) level on the indicator.

■ For example, if the highest peak used to check for a negative divergence
on the RSI or Stochastics formed above that indicator’s overbought line.

○ If price forms a double top (uptrend) or double bottom (downtrend) and the
corresponding pivots in the indicator have already changed direction, it shows a
loss of momentum so it is considered to be a divergence.

○ To check for divergence, first locate the prominent price pivot closest to the right
edge of the chart.

■ Look back from there to find the prominent pivot that formed prior to it.

■ Then look for the pivots in the indicator that correspond most closely to
those price pivots.

■ The pivots formed on the price chart and on the indicator will usually
occur the same day, or within a few days of each other.
●

● A negative (bearish) divergence occurs when price forms a higher peak during an
uptrend (from P1 to P2 in Figure 5.5) while the corresponding peak of the indicator either
flattens out or turns down (from A to B on the MACD histogram in the middle panel).

● For rising stocks, compare the prominent peaks in price to the corresponding peaks of
the indicator.(If it is not clear whether a divergence is present, look at the overall trend of
the indicator’s peaks as a guide.)
 ●

● A positive (bullish) divergence occurs when price forms a lower bottom during a
downtrend (from B1 to B2 in Figure 5.6), while the corresponding bottom of the indicator
either flattens out or turns up (from A to B on the MACD histogram).

● For declining stocks, compare the prominent bottoms in price to the corresponding
bottoms of the indicator. (If it is not clear whether a divergence is present, look at the
overall trend of the indicator’s bottoms as a guide.)

Failure to break a Prior peak or bottom

● For an uptrend to continue to rise:

○ Price must eventually close above each prior peak (swing high) that’s formed
as price pulls back from or consolidates within the trend.

○ Price must break above through each near-term resistance level during a
subsequent rally.
○ Price has to close decisively above each peak (swing high) rather than just a
marginally higher close i.e. closing 1 - 3 % above previous pivot high, orelse it
might lead to the formation of a double top (implying that trend may be
weakening instead of continuing its ascent)

○ Daily chart of CJES showed each peak being surpassed on a subsequent move
up until mid-March 2013.
 ○ During mid-march, price failed to break above the prior peak (forming a double
top in the process)

■ Its upper shadow did test that peak, but price didn’t close above it,
suggesting that the trend is losing momentum.

○ Prior to failing to break the prior peak in mid-march, the strong intermediate-term
up trendline was broken by the deep decline off the Feb top & possibly triggered
a protective sell stop for some long positions.

● For a downtrend to continue its descent:

○ Price must eventually close decisively below each bottom (swing low) that’s
formed as price bounces or consolidates within the trend.

○ Price must break down through each near-term support level during a
subsequent decline.
 ○ In late Dec 2012, price failed to move below the prior bottom, setting up a
potential double bottom in a downtrend.

● Note:

○ If the trend continues beyond the last prominent price pivot, then it was not the
top (or bottom) after all and traders will again be on the watch for the potential
topping (or bottoming) of the trend.

○ Early warnings don’t necessarily mean nailing the very top, or the very bottom, of
a trend.

○ Failure to surpass a prior peak (uptrend) or bottom (downtrend) is how double

tops and bottoms form, respectively.

○ Another test and failure of that high or low may result in the formation of a triple
top or bottom, respectively.

○ Those are only potential reversal patterns and must be confirmed. That means
the price must close below the lowest point between the peaks (topping pattern)
or above the highest point between the bottoms (bottoming pattern).
 ○ Remember, many unconfirmed reversal patterns turn out to be periods of
consolidation and are eventually followed by resumption rather than reversal of
the trend.

Change in Trendline Slope

● As price action evolves, you may need to adjust the slope/length of the trendline or draw
a new one.

● Correction alert: When you are forced to draw a steeper trendline due to an
acceleration of the trend.

○ This may cause the trendline to be broken soon since a steep ascent can’t be
sustained for very long.

○ Uptrend may not reverse completely but more likely to retrace part of that prior
steep ascent or move sideways to consolidate gains from the rise.
● In a declining stock or market: acceleration of the trend may occur to the downside.

● True Capitulation: When investors holding long positions finally give in and are willing
to sell off a declining stock at almost any price in order to exit their positions & end the
emotional (and financial) pain.

○ Once the panic selling is done, the stock or market becomes prone to a short
covering rally & may also draw in bottom fishers opening new long positions.

○ Will be accompanied by heavy volume and follows after a sharp decline.

○ Occurred on the charts of several U.S. stocks as the market declined into the
March 2009 bear market low.

● Trendline no.1: Started at the top of the IT downtrend, with only 2 touches on the line.
As the downtrend continued, it became too far away to represent the actual slope of the
trend.

● Trendline no.2: Was drawn as the trend got steeper.

 ● Trendline no.3: Was drawn across 3 peaks, identifying the new slope. When the decline
stopped and price changed direction from down to sideways from late May – Jul 2012,
all 3 lines were eventually broken.

Break of a Tight Trendline

● Break of a looser trendline would be typically considered a later stage reversal warning
since it lies relatively far away from the price action.

● When a tight trendline is broken, it can occur quickly enough to be treated as an early
warning.

● In a lot of cases, the tight trendline will be due to an acceleration of the trend (price
only pauses briefly several times during the uptrend) as shown in Fig 5.10

● On the daily chart of LHO, price first failed to push above the Jan 2013 peak in Feb 2013
(double top), flashing an early warning signal that the uptrend was losing momentum.

● Price was literally walking up the trendline i.e. a lot of rising bottoms touching it.

● Hence, the support trendline was broken very quickly when price turned down, providing
another early warning that the trend may be ending.
Approaching a Strong Ceiling or Floor

● Price may halt & begin retreating when it nears a major ceiling or floor even when
there aren’t any signs of a trend weakening.

● When an uptrending stock or index tests a strong ceiling (dotted line in Fig 5.13), the
trend becomes vulnerable to a reversal:

○ Many traders will use a strong ceiling as a target to exit their long positions or
at least take partial profits.

○ Alternatively, bearish traders may initiate short positions at or near the barrier.

○ As illustrated in Figure 5.13, the selling pressure forced price to retreat from the
ceiling.
● In a downtrend, when price approaches a strong floor (dotted line in Fig 5.14), many
traders holding short positions will cover them

○ Traders who are looking for an opportunity to go long may initiate positions
at/near the support area.

○ The subsequent buying pressure may push price up from the floor.

○ A break of a strong support level of an individual stock often occurs:

■ When the broad market declines.

■ If money rotates out of the sector/industry group that the stock belongs to
as traders take profits.

■ Due to the release of impactful news.

● Broad market environment may have a strong influence on whether the stock pushes
through a ceiling or declines below a floor:

○ Price is most likely to break through a strong resistance level during a bull market

○ Price is most likely to break below a strong support during a bear market.

● Note: Best to take partial profits or exit position even before price reaches a strong
barrier.
● Always check the chart on a higher timeframe (weekly) to look out for any historical
major resistance or support that may not be visible on the lower timeframe (daily).

● Strong resistance/support on the weekly chart serves as a significant alert for a

change in the trend direction on the daily chart:

○ The intermediate-term uptrend on the daily chart that began around mid-March
2013 came up against very strong resistance (dotted line) that stretched back to
2010.

○ That ceiling was the trigger for the start of the correction on the daily chart.
 ○ The stock is in an intermediate-term downtrend on the daily chart and it may
appear as if there is nothing to stop its fall.

○ However, looking at the weekly chart, it is obvious that this stock has been
trapped in a trading range for a few years and is approaching the floor of that
channel again.

● Strong MAs (50-, 100- & 200-period) and Fibonacci retracement levels may also
contribute toward stopping an intermediate-term retracement.

Candlestick Reversal Patterns

● Candlestick reversal patterns provide fairly short-term warning signals for swing
movement endings, which makes them useful for swing trading.

● However, there will be times where a strong candlestick reversal pattern marks the end
of an intermediate-term trend.
 ○ Nov - Dec 2012 correction ended with a bullish hammer.

○ A bearish dragonfly Doji formed on 2 Jan 2013 after an upward price swing. It
was then followed by a period of minor consolidation (basing)

○ After another upward swing, a Hanging Man (4 Feb 2013) was followed up by
another Bearish Engulfing pattern (5 Feb 2013), leading into a minor
pullback/consolidation.

○ After a next swing up, a bearish Hanging Man formed on 21 Feb and followed by
minor consolidation.

○ At the end of the next upswing, a bearish Shooting Star formed on 5 March,
marking the topping of the intermediate-term uptrend and its reversal point.

○ After a decline of almost 28% during March and April 2013, the correction ended
with back-to-back bullish candlestick reversal patterns i.e. a Hammer (printed
below recent price action so significant) & a Bullish Engulfing pattern. The
reversal was eventually followed by another intermediate-uptrend (not shown).

● Candlestick patterns are useful for identifying when a price swing may be weakening
or ending.
 ● They are formed frequently after short-term price swings, and are often followed by brief
interruptions of the intermediate-term trend.

● Look out for divergence signals or price testing a major support or resistance level
that will often support the candlestick signal at the end of an IT trend.

Responding to Early Reversal Warnings

● An early warning serves to alert traders to take some action on the trade before price
has reversed significantly.

● Always make protecting your capital and gains generated by that capital your highest
priority.

● Note: Although none of the early warnings guarantee that a trend reversal will occur, it
should encourage traders to be alert for additional warnings that the trend may be
weakening.

● Should go on the defensive especially if there’s more than 1 warning already present i.e.
a convergence of signals.

● Response to 1 or more warnings of a potential reversal depends on the following:

○ Risk tolerance.

○ Intended duration of the trade.

○ Rules and guidelines of the strategy employed.

○ The current broad market environment.

● Strategies to manage position:

○ Close the entire position to lock-in gains & avoid potential reversal.

○ Take partial profits & exit part of the position (⅓ to ⅔),

 ○ Tighten protective stop loss & not exit the position, fine if there’s only 1 early
warning sign but not recommended for multiple warning signs (better to partially
exit position at least).

○ Stop & reverse position on the stock in anticipation of a reversal based on

multiple warning signs i.e. from closing initial long to opening a new short on the
shares.

5. Late Trend Reversal Warnings

● Late warnings tend to occur when price is breaking down (uptrend), breaking out
(downtrend) or after a change in trend direction is underway.

● In some cases, by the time one or more of those warnings occurs, price will already be
considerably off the trend’s high or low.

● Both traders & long-term investors benefit from monitoring the intermediate-term trends
of the broad market.

● Late warnings provide useful signals & more evidence to traders to go long after a
downtrend has ended & go short after an uptrend has ended.

● Recommended to use the daily chart for analyzing intermediate-term trends.

● Once an intermediate-term trend has been in force for several weeks to a few months it
tends to get overbought (uptrend) or oversold (downtrend) and becomes vulnerable to
a correction. Hence, traders should take steps to lock-in profits when one or more signs
of weakness occurs.
Break of Support and Resistance

● For an uptrend to continue

○ Price must eventually surpass each new higher peak that forms during a trend.

○ Price should find some support at the previous peak when it pulls back.

○ Hence, when price has been trending up but closes below support, the uptrend
may be changing direction.
● For a downtrend to continue:

○ Price should surpass each new lower bottom that forms and find resistance
during each subsequent bounce.

○ Hence, when the price has been trending down but closes above resistance, it
could be a sign that the downtrend may be reversing direction.

○ The broken declining trendline + subsequent breakout above the narrow trading
range (horizontal trendline), were good indications that a new uptrend was
beginning to show.
Break of a Strong Sloping Trendline

● Break of an Upward Sloping Trendline

○ Always maintain an intermediate-length support trendline connecting the

prominent higher bottoms when monitoring an uptrend.

○ A close below the rising support trendline is required to declare it as a valid

break.

○ Potential to have a good risk-to-reward entry to short the stock as it bounced

back and tested the resistance level that was initially an area of support.

○ The bounce also served as an opportunity for longs to exit their positions to
preserve gains or cut losses accrued before further downside moves occurred.

● Break of a Downward Sloping Trendline

○ Always maintain an intermediate-length support trendline connecting the

prominent lower peaks when monitoring an uptrend.
 ○ A close above the declining resistance trendline is required to declare it as a
valid break.

○ Note: The break of a strong trendline does not necessarily mean a significant
trend reversal is imminent. Sometimes the trendline is broken during a shallow
basing or deep pullback (up trendline) or strong bounce (down trendline) and the
stock resumes the prevailing trend shortly after.

○ Simultaneous breakdown of both the rising up trendline and the horizontal

resistance turned support line, provide a strong late warning that the prior trend
has come to a halt.

○ Early warnings in the form of the shooting star and bearish engulfing (together
formed a mini-double top), had materialized before price broke down.

Break of a Strong MA

● During a strong uptrend where the security goes through only minor/short interruptions,
price may tend to remain above the 20-period & 50-period SMAs for a period of time.

● 20 SMA can be broken relatively quickly but will take a more stronger move to break the
50 SMA & by then a correction may be underway.
● A minor correction may cause price to tease or hover near the 50 SMA, but a deeper
correction will break it.

● Breakdown below a Strong MA

○ Price remained above the 20 SMA throughout the entire IT uptrend.

○ Price closed below the uptrend line & below 20 SMA, found resistance there as it
traded sideways for the next few days

○ Price then gapped down below horizontal support and made a significant decline
intraday, triggering the start of deeper pull back.

○ Note: Sometimes the 20-period SMA is broken during a pullback but the stock
rebounds shortly after or 20 SMA could flatten out such that price closes above
and below it during that period.
 ○ Price may break down below the 20 SMA after making a sharp and extended up
swing, possibly causing the stock to become overbought.

● Important: The key is to watch for more evidence of a solid breakdown (e.g., the break
of a trendline or horizontal support line) when price is near to the moving average.

● Breakout above a Strong MA

 ● In summary:

○ In the early stages of a trend reversal, watch for short-term moving averages to
be broken as a warning of a potential reversal.

○ Once the change has occurred and price is trending the other direction, watch for
longer-term moving averages that have been farther away to provide potential
support or resistance.

Change in Direction of Peaks or Bottoms

● Up to Down: When the direction of the prominent price peaks shifts downward, it is a
sign the uptrend may be reversing direction (Figure 6.8).

○ Once a new, prominent lower peak is present, a down trendline can be started
above and connecting the declining peaks.

● Definition of a Prominent price pivot: One where there is a clear support or resistance
level created by the pivoting action (or formed from minor consolidation).
● Down to Up: After a downtrend, if the prominent bottoms begin rising (Figure 6.8), the
trend may be in transition from down to up.

○ Once a new, prominent higher bottom is present, an up trendline can be started

below and connect the rising bottoms.

● Head & Shoulders Top

○ H&S is not confirmed until its neckline is broken.

○ However by then, a reversal may sometimes be well under way especially if it’s a
downward sloping or upward sloping neckline.

○ Earlier warning for this pattern is simply the change in direction of the prominent
peaks.
6. Multiple Warnings

Early Warnings

1. Climax Move → Price gapped up strongly on Feb 14, 2013 accompanied with heavy volume,
creating a potential exhaustion gap. This was confirmed when it was filled several days later but
provided subsequent support later so not a great concern yet.

2. Failure to Break the Prior Prominent Peak → Price turned up after filling the gap and tested the
prior Feb high in March, setting up a potential bearish double top pattern.

3. Negative Divergence → Test of the prior peak corresponded with a negative divergence between
price and the MACD.

4. Trendline Break → Intermediate-term trendline was decisively broken on April 2, 2013.

Late Warnings

5. Strong MA Break → Price closed below the 50 SMA the following day.

6. Declining Peaks → Direction of peaks shifted from rising to declining.

 7. Final break of Horizontal Support → The support line where price initially filled the exhaustion
gap was broken on April 12.

Moral of case study

● Take partial profits on an open core position at least when early warning signs start to
emerge and remain defensive stance on the balance.

● Be prepared to enter an opposite trade on the security to get in early on a possible

change in trend direction.

7. Monitoring Broad Market Trends

● Look at the short-term swing moves on the chart of a major market average and the
stock when managing a swing trade.

● Continually monitor the strength of the short-term market trends and watch for signs that
the minor trend may change direction.

● The intermediate term trend provides the overall guidance, but the short-term
movements provide the entry and exiting opportunities.

● Intermediate-term movements are easier to follow and monitor than the major trend,
which is significantly longer; and by continually monitoring them, you’re indirectly
monitoring the long-term trend already.

● Remember:

○ Most long-term trends are strung together by a few to several intermediate-length

moves.

○ The last leg up in a bull market and the last leg down in a bear market is usually
an intermediate length move leading to the final top or bottom
 ● When monitoring intermediate-length trends within a major trend, zoom out to the weekly
chart to get a bird’s eye view of the entirety of the trend & to identify major support and
resistance levels.

● Both the Dow and S&P 500 are large-cap indices widely used by chartists

Monitoring IT Market Uptrends

● While the market is moving up for a period of time in the direction of the major trend →
Primarily focus on long trades and continually monitor the trend to gauge its strength.

● Can utilize bases/flags and pullbacks against the uptrend as setups, for initiating or
adding to a position.

● Maintain a bullish stance until the trend begins to become overbought on an

intermediate-term basis, and/or warnings of a potential trend reversal emerge.

● Recall that an intermediate-term trend typically lasts from about one to three months and
the movements that are in line with those of the major trend tend to last longer than the
corrective moves.

● Be cautious when the upward move approaches 3 months or more i.e. the far end of its
duration range, it becomes more prone to exhaustion and potential correction.
● Actual sell signals needed before closing long positions.

● Caution increases with overbought trend and reversal warnings.

● Be selective and conservative in trade management.

● Capture uptrend, minimize exposure to potential market declines.

● Maintain sloping IT trendlines:

○ Reason to readjust IT trendlines: If it’s broken by a minor trend interruption

such as basing action or a pullback, and price subsequently recovers rather than
breaking down further.

○ Intermediate-term up leg lasted from Nov 2023 to late May 2013

○ First trendline broken by a pullback from April 15 to 18, of only 2.2% decline.

○ Second trendline was drawn after the price turned up & formed a new price pivot.
The 2nd trendline continually extended upward with slight adjustments to the
slope.

○ Price pulled back almost 3% again from May 29 – June 5, and price turned up to
form a new higher bottom. 3rd trendline drawn again and was extended upward
with adjustments to the slope.
 ○ Break of the 3rd trendline resulted in a deeper correction.

● Map out Horizontal Support & Resistance levels:

○ Minor support & resistance zones created from the up/down price swings &
periods of minor consolidation in the short-term.

○ Some of these levels will become more significant than others.

○ Support and resistance lines may reverse roles.

○ Levels that are continually tested or touched multiple times will be closely
monitored by participants.

○ Top put out by the end of an IT uptrend will become an important resistance
level.

○ Remember to maintain and extend more longer-term resistance/support levels

○ Maintain short horizontal lines (H1 & H2) to focus on the recent price action.

○ A break above H1 signifies a continuation of the uptrend and a potential trend

reversal for a break below H2.
 ○ Extend the horizontal line to the right edge of the chart if price is still using it as
support and/or resistance such as the case for H3 & H4.

○ Notice how price approached H4 a second time as support after price made a
deeper pullback.

○ Line H6 was extended to the right since it represented the top of the prior
intermediate-term uptrend and also the bull market high at that time. This makes
it a key resistance level.

○ The market had to move above H6 in order for the major uptrend to continue its
ascent, which it did in July 2013.

● Always keep the strongest of the lines and the ones closest in proximity to the
right edge of the chart (which are in play) to avoid chart clutter! E.g. below:

○ Some of the past lines shown in Figures 10.2 and 10.3 have been erased.

● Analysis of the Intermediate-term movements is done on the daily chart. Thus,

primary trendlines for those movements are maintained on that time frame.

● Periodically check the weekly chart to be aware of the longer-term sloped trendline(s)
and the major support and resistance areas including key moving averages.
 Warnings of a Market Trend Reversal

● The movement of most stocks is influenced by the broad market (and/or by the sector to
which that stock belongs).

● A warning(s) of a potential reversal of the trend of the market average suggests many
stocks have lost momentum, and some may already be shifting direction.
Tracking Bull Market Correction
● An up leg within a bull market becomes overbought on an intermediate-term basis after it
has typically run for several weeks to a few months.

● This is often followed up by a retracement of a portion of that uptrend i.e. a correction,

which creates oversold conditions for another leg up to begin.

● A correction is often much shorter in duration, and of less magnitude than the prior up
leg.

● There may be instances when a correction lasts longer—some will go on for several
weeks and some for several months.

● And there will be instances where the correction is deeper, erasing the entire prior
uptrend, and in some cases even continuing beyond that prior correction low.

● Minor corrections: There will also be instances where the correction is mild. It may
even be a short-term downtrend rather than an intermediate-length correction. That is, it
is deeper than a standard market pullback, but not as deep as a standard correction.
E.g. a decline to about the 50D-SMA.

● As a bull market correction begins, the question is how far will it fall?

● If you want to participate on the long side during the next leg up, closely monitor the
correction in order to recognize when an upside reversal occurs.

● Once a new up leg gets under way, there is often plenty of potential for profits. That’s
why it pays to focus on recognizing when a new up leg may be starting after a correction
—in order to work that upward movement again on the long side.

● If you wish to open one or more short positions, monitor the decline for a good reward-
to-risk entry opportunity (e.g., a bounce to an area of resistance).

● When participating in a correction by shorting, monitor the decline in order to protect the
profits built up in your short position(s).
● A bull market correction can be a great opportunity to buy stocks at lower prices.

● Watch the correction like a hawk using the daily chart to monitor it for developments that
signal the correction may be ending.

● The goal is to participate in as much of a trend as possible, in whichever direction we are

trading, while not deluding ourselves into thinking we can always nail the very tops and
bottoms of the trends!

● Identify major support below: Logical levels where traders may initiate long positions,
and for shorts to cover, which may stop the decline

○ Strong moving averages – Minor corrections may find support at 50 SMA while
deeper ones may test 100/200 SMAs.

○ Price pivots – A single prominent price pivot, multiple pivots (e.g., the top of a
prior trading range), or a tight area of congestion (a base) may be present on the
chart.

○ Gap Opening – Price may fill back into a prior gap. The gap’s opening may
provide support.
● Fibonacci Retracement Levels

○ During a correction, price will often retrace from one-third to two-thirds of the
prior upward move.
 ○ Pay attention to the well-known Fibonacci retracement levels of 38, 50, and 62
percent.

○ After correcting during October–November 2012, S&P bounced right at the 62

percent Fibonacci line.

○ Plot a Fibonacci grid across the prior uptrend as a correction begins in order to
identify those levels.

○ You don’t have to leave the grid up if you find it bothersome, but note the levels
in your trading journal; or if there is other support at/near that level, draw a
horizontal support line on the chart.

● Bottoming Price Action

○ During a market correction, watch for bottoming price action as the decline
progresses.

○ In some cases, the bottoming action will be a well-known reversal pattern, such
as a double or head-and-shoulders bottom.
○ A correction often ends in a much quicker fashion. In some instances, it will be a
very small version of a bottom reversal pattern.

○ So small that it is really just a double or triple “tapping” action. But it has the
effect of price putting in a low and then testing it once or twice immediately after.

○ Experienced traders know the importance of this price behavior.

○ Figure 10.8 shows a daily chart of the S&P 500 Index during 2010. The August
and November corrections both ended with the small triple-tap movement
mentioned above.

○ They are not triple bottoms on the daily chart. They are simply too small to meet
the criteria—they don’t contain enough bars, and are not deep enough.

○ But remember that a price swing on the daily chart is a downtrend on lower time
frames. Thus, if you were to look at this little triple-tap action from an intraday
perspective, it would be a very obvious triple bottom to those viewing the intraday
time frames.
 ○ While these small bottoming patterns may not be enough to reverse a major
downtrend, they are enough to put in the bottom of a correction within a long-
term uptrend.

○ Remember, it is a bull market and many traders have a buy-the-dip mentality.

They don’t want to miss out on the next leg up any more than I do. They are
looking for those re-entry opportunities.

● Candlestick Pattern or Western Reversal Bar

○ Watch for the emergence of a candlestick reversal pattern.

○ Quite often a new leg up from a correction starts from a reversal signal consisting
of one bar (e.g., a Bullish Engulfing pattern or a Hammer) to a few bars (e.g., a
Morning Star).

○ Sometimes volume helps to confirm the move. Heavy volume often accompanies
the long candle or the candlestick reversal pattern.

○ In the instances in Figure 10.8, the market volume (not shown) was not
remarkably high during either of those long candles; however, volume has been
tricky throughout much of the current bull market.

○ The typical price to volume relationships have not been present at times during
this major uptrend, which has been frustrating for many chartists because volume
is one of our primary tools.

○ However, we must adjust to the market conditions. And that doesn’t mean the
typical relationships won’t resume at times as the current bull market progresses,
or be prevalent again in future bull markets.

○ The typical price to volume relationships have not been present at times during
this major uptrend, which has been frustrating for many chartists because volume
is one of our primary tools.

○ However, we must adjust to the market conditions. And that doesn’t mean the
typical relationships won’t resume at times as the current bull market progresses,
or be prevalent again in future bull markets.