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Anatomy of a Healthy Chart Pattern: A Guide for Stock Market Investors
How to Identify and Analyze Strong Market Trends for Better Trading Decisions
I see more and more traders being sucked into trades lead by FOMO. This is one of the specialities of the bear market. Hence I decided to devote this weeks email to an important fundamental understanding: The HEALTHY CHART PATTERN. One of the most effective ways to do this is by analyzing its chart pattern. In this article, we'll explore the anatomy of a healthy chart pattern and the key indicators to look for when analyzing a stock.
Table of contents:
1. Understanding Base Patterns 2. Analyzing Volume Bars 3. Importance of Stage Count 4. Understanding the Up/Down Volume 5. Practical Takeaway Checklist 6. Practical Examples 6.1 FLT 6.2 DDD 6.3 NFLX 7. Conclusion
I. Understanding Base Patterns 🏗️
A base pattern is a price consolidation, where a stock is trading within a range. To understand the health of a base, investors look at how it's reacting to the 50-day and 21-day moving averages, as well as the volume of trades. If a stock is finding support and trading above the 50-day moving average, it's a good sign that it has the potential to be a leading stock.
Bases are a necessary key for any breakout trader. If the stock is not in a base, the probability of the breakout is significantly reduced. By analyzing the greatest stock winners since 1900, we have concluded the most common base patterns that have produced the largest winners. We have a series “Anatomy of [BASE NAME]", to provide the exact characteristics of what the base requires to be proper. Some of the most probable bases are: Cup with handle, High Tight Flag (or Powerpay), Double Bottom or Flat Base.
II. Analyzing Volume Bars 🌊
To gauge the level of buying and selling activity for a stock, investors use the volume bars. If the price of a stock is going up and the volume is above average, it suggests that there is support at that price. Conversely, if the price of a stock is going down and the volume is below average, it suggests that there is not much selling taking place.
A great analogy of using the volume bars is that the price is the direction and the volume is the gas tank. If the price is moving in the right direction and has a large gas tank it will likely continue moving in this direction and for longer. This is the base of momentum trading.
III. The Importance of Stage Count 🧮
Another important factor to consider when analyzing a stock is the stage count. This comes as a lesson from the legendary trader William O’Neil and is covered in his book “How to make money in stocks”. If a stock is in its first or second stage, there is a high probability that we are in the beginning of a larger price move that is taking place. On the other hand, if a stock is in its third or fourth stage, the probability of large price moves taking place decreases. In such cases, traders may want to be more defensive and be more suspicious of abnormal moves. In any case advise is to cut losses religiously and keep your long term average loss at single digits (preferably 8%).
IV. Understanding the Up/Down Volume Ratio 🧪
The 50-day Up/Down volume ratio is another key indicator to look for when analyzing a stock. The formula is simple:
Up/Down ratio = Total volume of Up days / Total volume of down days
This ratio gives investors a numerical value for the strength and weakness of a pattern. A ratio above 1.1 suggests that there is more demand for the stock, while a ratio below 1.0 suggests that there are more down days than up days. A volume ratio of 1.1 and above is the cherry on the top that you would like to see.
V. Breaking Out with Above Average Volume🔮
Finally, when a stock breaks out, it's important to look for above average volume. A minimum of 20% above its 50-day average volume is recommended to ensure that the stock has momentum and is likely to continue its upward trend. For more conservative plays look for 40% higher volume than the 50-day average volume. My [TTI] Volume + indicator can print those and they look like this and the threshold is gully automatic:
✅ Practical Takeaway Checklist:
Look for a base pattern that is consolidating within a range and is finding support above the 50-day moving average.
Analyze the volume bars to gauge the level of buying and selling activity for a stock.
Consider the stage count to determine the probability of large price moves taking place.
Look for a 50-day volume ratio above 1.1 to indicate demand for the stock.
When a stock breaks out, look for above average volume of at least 20% above its 50-day average volume.
Introduction: In this section, we will look at some practical examples of healthy chart patterns. We will examine the price and volume action on the weekly chart of several stocks and see what the patterns are telling us.
Fleetcor (2012): FLT 0.00%↑
Let's take a closer look at the Fleetcor example from 2012. In this case, our pattern recognition tool automatically identified the price consolidation as a cup pattern. But what really stood out was the volume. As the price consolidated, we saw "blue skyscrapers" appearing, indicating a steady rise in volume even as the price stayed up. This is a strong sign that the stock is being supported and is not likely to drop.
When the stock eventually broke out, it was on above average volume, which is a key indicator that the breakout is likely to be sustained. Furthermore, the price action around the 10 week moving average line showed signs of institutional support, as the stock bounced off the line and immediately retraced upwards. Again keep an eye on the volume when this happens.
This is a great example of why it's important to study both the price and volume action on a weekly chart. By analyzing the patterns and indicators in the chart, traders can gain a better understanding of the underlying health of a stock and make informed decisions about when to buy or sell.
NB. The green volume bars on the [TTI] Volume indicator represent a Pocket Pivot Signature. The Pocket Pivot is a bullish trading signal that signals institutional buyers. It is represented by an above average bullish bar close to the 50-day moving average, higher than any other bearish bar in the last 10 days.
3D Systems (2012): DDD 0.00%↑
In 2012, 3D Systems provided a great example of this dynamic. Using pattern recognition we identified the stock as being in the first stage of a base, with the volume building up in preparation for a breakout. As the stock moved higher, it closed on the weekly middle bar, indicating support, and bounced off the 10-week line, a sign of institutional support. As the volume continued to build, the stock eventually broke out, with the volume being above average on the breakout day. This is the type of price and volume action traders look for when analyzing a stock.
It is important to weight more emphasis on the pocket pivots that are within the base formation pattern. This is because they represent the powerful thrust that signals institutional support.
Netflix (2012): NFLX 0.00%↑
Netflix in late 2000 provides a great example of this. After a big move higher, the volume dried up, and the stock consolidated for a bit before eventually breaking out again on above average volume. Since the stock rarely corrected after this big move we can conclude that this type of action is a telltale sign of a healthy chart pattern, and traders should look for similar price and volume action when analyzing a stock. In addition, traders also pay attention to how the stock reacts around key moving averages, such as the 10-week line and the 50-day line, as well as how the up/down volume ratio is behaving. By combining all of these elements, you can gain a more complete understanding of the health of a chart pattern.
I have amended the settings here so that the highlighted areas represent only the bullish above average volume bars.
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In conclusion, when looking at chart patterns, it is important to keep it simple and focus on the price and volume action. Look for blue skyscrapers, price consolidation, above average volume, institutional support, and a rising RS line. These are all signs of a healthy chart pattern that is likely to continue to perform well in the future.
Look at the price and volume action on the weekly chart
Look for blue skyscrapers, which indicate buying
Look for price consolidation and above average volume on the breakout
Look for institutional support, as indicated by the stock finding support at the 10-week line
Look for the up/down volume ratio to be 1.1 or higher
Look for the minimum of 20% above its 50-day average volume on the breakout
Look for the stock to outperform the S&P 500 by having a rising RS line
Keep it simple and look at the pattern to see what story it is telling you.