Trading What I See

Notice that on the Daily chart we are having trouble at the inner channel that I have been pointing out over the last several weeks. We still may get to the outer channel, but on previous rallies there has been no pause at the inside trendline. We’ll have to wait and see whether this is significant.

Because yesterday I mentioned the triangle on a longer term chart, I want to use it as an example of how I think about patterns. The first stock market book I ever bought was Edwards and Magee’s Technical Analysis of Stock Trends. This was written before many of the tools we use today became widely available, so I spent years trading with just trendlines and the patterns they created on the charts.

I finally decided that price interaction with the channels created by parallel trendlines were the real reason that most patterns worked. When you have a strong, continuous trend, price will oscillate above and below some type of center of gravity, creating the channel. The center of the channel is often shown by a short moving average or a linear regression.

When some counter force comes into play, the trend will pause or reverse, and this is what creates the patterns that chartists have traded for years. I’ve tried to illustrate this on the accompanying 10 minute chart. Here you can see the interaction of an up channel and a down channel.

Yesterday’s triangle is shown in yellow. If price had broken to the upside, my first target would have been the green line drawn parallel to the lower edge of the triangle, or the top of the up channel.

But since we broke down, I am assuming that the reverse will happen, and the red line drawn parallel to the top of the triangle would become my first target. In this case we are following the down channel.

In either case, all I am doing is following my normal practice of drawing trendlines from pivots, and then drawing the parallel to form a channel. This automatically puts the various charting formations, from head and shoulders, to triangles, to wedges on my charts.

By thinking about channels, in addition to the patterns, you gain a little more insight into what the market is actually doing. For example a triangle will usually reach the first target (parallel line) quickly.

Todays drop was quick, but we didn’t quite get to target. This tells me that the downward force was not extremely strong. This concept holds true in any channel, as a failure to reach the opposite edge is often the first sign of a change in trend. Just remember that a change in trend can be to sideways as well as a reversal.

For the moment, we are still in a down channel on this 10 minute chart. When we get the next pivot bottom, I’ll draw a new trendline and its parallel. Maybe I’ll get a new channel. Perhaps a new pattern. But bar by bar, that’s how I track the market.

Edwards and Magee’s Technical Analysis of Stock Trends