The easiest types of broadening formations to detect are those with a “flat- tened” bottom or top, as shown in Figs. 10-2 and 10-3.
These patterns are sometimes referred to as right-angled broadening for- mations. Since the whole concept of widening price swings suggests highly emotional activity, volume patterns are difficult to characterize, although at market tops, activity is usually heavy during the rally phases. The patterns at both bottoms and tops are similar to head-and-shoulders patterns except that the “head” in the broadening formation is always the last part of the pattern to be formed. A bear signal comes with a decisive downside break- out. Volume can be heavy or light, but if activity expands at this point, this is an additional bearish factor.
Since a broadening formation with a flattened top is an accumulation pat- tern, volume expansion on the breakout is an important requirement, as
shown in Fig. 10-4. In my experience, these formations pack a punch far greater than their size would suggest. They are really head-and-shoulders tops (bottoms) where the situation is so bearish (bullish) that the price does not have any time to trace out a right shoulder.
Figure 10-2 Right-angled broadening top formation.
Figure 10-3 Right-angled broadening bottom formation.
The Underlying Psychology
Broadening formations with a flat top usually appear as the culmination of a persistent downtrend. At the start of the formation, bearish sentiment is typically quite excessive. The price initially sells off, then subsequently ral- lies to the horizontal level of resistance. When the bears see that the resis- tance has held, they are emboldened to put out more shorts, and a decline sets in. The price then rallies again and finds resistance in the area at the top of the pattern, but the advance from the second low is not sufficient to cause the shorts to cover. Indeed, when the price fails to rally through the resistance, the bears are even more emboldened to put out even more shorts.
As the price falls below the previous low, latecomers are attracted to the short side. After all, they can see that in the past few weeks and months, there was easy money to be made from shorting, especially as the news back- ground is so negative that prices are “sure” to go down a lot more. This is enough to panic weak holders, who experience the give-up phase and liq- uidate to anyone “kind” enough to take the security off their hands. If bear- ish sentiment was widespread coming into the pattern, it is now universal, as virtually everyone is a believer in the bear trend. Those who are left are either strong holders with a positive long-term belief in the eventual out- come or short sellers. The bottom line is that there is little or no selling pres- sure but lots of potential buying pressure from the mercurial shorts.
Figure 10-4 Right-angled broadening bottom formation.
The gasoline is on the fire. All that is needed is a match. That could be provided by unexpected good news, a change in the direction of the over- all market, or some other reason. Perhaps the news is particularly bad and the price does not decline. This type of action will spook the shorts, who argue that if bad news won’t cause a further decline, nothing will. The rea- son is immaterial. What matters is that the price starts to rise, and rise quickly, fueled by some short covering and bargain hunting. It then explodes through the resistance represented by the horizontal trendline, and the pat- tern is completed. Buyers are reluctant to enter at this level because the price has already risen substantially from the low. However, those with a long- term conviction are not deterred. Also, traders who are still struggling to cover their short positions continue to buy. Remember, those who are short are not thinking about the downside risk; they are worried about the unlim- ited upside catastrophe that will occur if prices continue to rally. Virtually everyone who shorts has a relatively brief time horizon, so the rally coming off a broadening low has the feel of a huge unexpected bull market. There is only one solution: Cover before prices go any higher!
The reason why the rally extends probably arises from the utterly and com- pletely bearish environment at the low. Anyone who was previously long and wanted to get out has already done so. As a result, the security in question is held either by long-term believers or by shorts. One isn’t going to sell, and the other literally has to buy.
The psychology at tops is exactly the opposite. Here, the formation starts after a persistent advance, which encourages widespread optimism as the price makes successive new highs during the development of the broaden- ing part of the pattern. Naturally, these progressively higher rallies dis- courage the shorts. They probably place stops just above resistance, which they judge to be at the previous high. After a couple of attempts at this, they give up. This means that at the final top, there is a very small short position.
Large short positions act as support for declines; small ones do not.
Since the pattern develops after a fairly lengthy advance, new buyers are attracted every time the price rises to a new high because there is no feeling of downside risk. Unfortunately, these new players are of much poorer qual- ity than, for example, the type of person who held on through the final throes of a broadening bottom. These participants are attracted by the good news and attractive prospects being painted by the media, brokers, and others. The progressively stronger rallies associated with this pattern also result in care- less decisions, since rising prices bail out the greedy and inexperienced buy- ers who become accustomed to a one-way street. These are indeed LIFO buyers—last in, first out. Consequently, when the price reaches its final peak, holdings are concentrated among uninformed and weak holders. To make matters worse, there is very little cushion in the form of short positions. Prices
then begin to decline rather rapidly. Since a quick sell-off of this nature is unexpected, few are able to get out at the beginning. As the price falls through the support at the horizontal trendline, it attracts more selling, but any short covering that would normally have taken place at the support trend- line is not available as a result of previous short squeezes. Therefore, prices continue to fall. The ensuing decline is fairly persistent because it takes a long time to liquidate the weak holders who bought the security in the heady days when the top was forming.
Measuring Implications
The measuring objectives for these patterns are taken from the maximum distance between the peak (or the bottom, in the case of accumulation) of the formation and the horizontal line. The distance is then projected from the breakout point in the direction of the breakout.
Right-angled broadening formations can experience retracement or pull- back moves just like other patterns. Because they are fairly violent and unstable, these retracements can be extremely sharp und unnerving.
Fortunately, they are normally short-lived.
Chart 10-1 shows a right-angled broadening top for Intel. In this case, the downside objective was reached during the breakout move. It is unusual to
Chart 10-1 Intel, daily.
see such a quick reversal after this pattern has been completed, since prices normally drop or rally far more than the indicated objective. In this respect, the top in Ericsson in Chart 10-2 is a more typical example. Note also the retracement move that developed right after the breakdown. This would
Chart 10-2 Ericsson, daily.
Chart 10-3 Aetna, daily.
have been quite unnerving to anyone who had gone short on the breakout, since there was no logical low-riskresistance level above which to place a stop.
Another example of a right-angled broadening bottom appears in Chart 10-3, for Aetna. This time the broadening or diverging part of the forma- tion is more controlled and not that deep. The breakout and subsequent move are also more constrained.
Generally speaking, the broadening variations pack a great deal more punch than an equivalent-sized head-and-shoulders pattern. Just take a look at Chart 10-4, featuring a monthly close of the Dollar Index. In this instance, the price rallied very quickly to five times the objective.
Where to Draw the Lines
A lot of the time, it is necessary to use a little poetic license when construct- ing these patterns. Let’s consider the accumulation variety in this explanation.
What we are really trying to construct is a reverse right-angled triangle, as shown in Fig. 10-5. Note that because of the jagged nature of the price action, it is not possible to join all the rallies and reactions exactly. Often we have to com- promise on an approximate area of resistance for the horizontal part of the formation, for example. If you think of the underlying psychology of the pat- tern as described earlier, everything still fits. The unfortunate thing is that there are rough approximation points rather than black-and-white signals that give us greater confidence in the completion of these patterns.
Chart 10-4 U.S. Dollar Index, 1975–1983, monthly.
Charts 10-5 and 10-6 both feature bottoms for the Philadelphia Gold and Silver Share Index. In Chart 10-5, each of the lines is temporarily breached once, but there is no doubt that the formation reflects the broadening con- cept with a flat top. The initial rally (A) in Chart 10-6, on the other hand, presents us with a bit more of a challenge; however, if the angled line is
Figure 10-5 Right-angled broadening bottom formation featuring shape.
Chart 10-5 Philadelphia Gold and Silver Share Index, daily.
brought back to the apex, it is evident that it forms part of the pattern.
Note that the angled or diverging line was approached or touched on numerous occasions and therefore represented substantial support. It also gave the pattern more credibility, so when the breakout through the hor- izontal trendline did take place, it was followed by a very worthwhile move.
The multiyear bottom in the Dollar Index (Chart 10-4) also presented a small challenge in construction, since both lines were exceeded once.
However, there can be no denying the exceptionally strong rally that fol- lowed.
Right-Angled Broadening Formations as Consolidation Patterns These broadening formations can also develop as consolidation patterns, as shown in Fig. 10-6 for an uptrend. Chart 10-7, for the copper price, shows a consolidation right-angled top. The achievement of triple the downside objective indicates that these formations should be respected as much as the tops and bottoms. Note the broadening bottom that formed at the end of the decline. The angle of descent was quite sharp. If you look at the exam- ples in this chapter, you will see that there is a very rough correlation between the angle of the broadening part and the speed of the ensuing move. Thus, the sharper the angle (the greater the volatility), the more likely it is that a precipitous decline or explosive rally will follow.
Chart 10-6 Philadelphia Gold and Silver Share Index, daily.