Find Turning Points With Single-Day Patterns
Technical analysis has a reputation for being complicated and time consuming, but there are many quick techniques that can provide an easy starting point for further research. While single-day patterns should not be relied on exclusively, they can be extremely useful as an on-the-spot analysis to identify potential market turning points. This article will introduce three single-day technical patterns and show how they can be effectively used in everyday trading.
Filling the Void with Gaps
Gap days occur when a day's low is above the previous day's high or a day's high is below the previous day's low, thereby creating a gap in the y-axis of the chart. These chart patterns occur as the result of unexpected news and can be used to identify changes in investor sentiment as well as gauge the strength of new, longer-term trends.
Since gaps most often occur as a result of unexpected news relating to a given security, such as earnings guidance, new products, regulatory approvals, acquisitions or scandals, they are far more common among individual stocks than indexes. However, gaps can also come as a result of strong changes in overall sentiment, marked by a cluster of buy orders at a higher or lower price.
There are four common types of gaps: common gaps, breakaway gaps, runaway gaps and exhaustion gaps. The most important ones for our purposes are breakaway gaps and runaway gaps, which provide reliable indicators that can be used to profit. The first can be best used if anticipated beforehand, while the latter can provide an excellent signal of future trends. (To learn more about gaps, check out our Analyzing Chart Patterns Tutorial.)
Anticipating breakaway gaps is easiest when there is a clear technical pattern and a strong trend that can be reversed. Buy or sell orders can then be placed either slightly above or below the breakout level, inside or outside of the trading range. Meanwhile, traders can buy into runaway gaps, as they often signal an intensifying trend going forward.
Here are two examples to illustrate these ideas in Amazon.com's 2007 history:
|Figure 1: The breakaway gap follows the smaller breakout from the original trend.|
|Figure 2: The runaway gap, in the direction of the previous trend, predicted a continuation.|
All in all, gaps can provide traders with many opportunities to profit either before or after the move. Breakaway gaps can signal profits for traders that put in limit orders around breakout levels, while runaway gaps can help investors identify strengthening trends.
Finding Turning Points with Island Reversals
Island reversals are single price bars, or groups of bars, sitting at the top of a price move and isolated by a gap on both sides, before and after the island pattern. When accompanied by high volatility and volume, this pattern can provide a reliable indicator of a major turning point, and therefore should be watched closely by any traders.
It is important to note that island reversals may not immediately signal a reversal of the trend, but they are often precursors to a big change in sentiment. In fact, a stock's price may even retest an island reversal's high before a turnaround takes effect. It can also be very helpful to look at the associated candlestick patterns - notably the doji star or engulfings - which can provide further insights into the price movements. (For more on patterns like the doji, see Day Trading Strategies For Beginners.)
Here is another chart showing an island reversal in Amazon's chart, where the stock reached over $100 per share before dropping sharply to approximately $80 per share after the pattern.
|Figure 3: The island reversal predicted a dramatic change in the prevailing trend.|
Interpreting Wide-Ranging and Inside Days
Wide ranging days and outside days are long bars that are often caused by a price shock, unexpected news or a breakout situation that caused increased volatility. Meanwhile, inside days take place when the high is lower than the previous day's highs and lows are above the previous day's low, representing a period of consolidation and lower volatility.
Wide ranging days are exactly what they sound like - days in which the price range is far beyond normal. Since extreme volatility isn't usually sustainable, wide-ranging days are often followed by some type of reversal or a pause in the market. The direction of the close - whether near the high or low - can often be a good indicator of continued direction.
Inside days often take place after the end of a price move, where prices have reached a point where buyers are already in and the price has moved too far to attract more buyers. Oftentimes, these inside days are followed by a change of direction, provided that no further news materializes to send the price higher.
|Figure 4: The inside day marked consolidation before a significant run-up.|
Single-day patterns cannot often be used to profit on their own, unless traders use a lot of discretion when choosing the situations. After all, single-day patterns occur often by definition, and such a high frequency tends to make them less reliable and profitable than longer-term patterns, such as triangles or continuation patterns.
However, single-day patterns are excellent when used with other forms of technical analysis and can be used in some types of very specific situations. For example, in times of high volatility, being able to pick a more exact top can help in exiting or reversing a position for active traders. In this case, island reversals or inside days can prove extremely useful.
For more on technical analysis, see our Technical Analysis Tutorial and Blending Technical And Fundamental Analysis.