indicative of a change of direction nor does it have other apecial attributes; hence it is called "common." Both runaway gaps and midway gaps refer to those price jumps occurring within a strong trend. They are associated with periods of illiquidity within a move; this could be the result of additional news to encourage the bulls or bears, or it could be a critical chart formation or anticipated reversal point that fails. Runaway gaps indicate stronger moves

The eshauation gap or island reversal is the culmination of a major move; unfortunately, it is a formation only identifiable after the fact. If the price move has been exceptionally extended, it is likely that the first gap reversal will be the beginning of the trend change; however, there is a great rid; associated with it.

Gaps are a hindrance rather than an asset to trading. A breakaway gap usually causes stop-loss orders to be executed far away from the stated price. If a long position is entered in anticipation of a breakout, that breakout never occurs and a high price is guaranteed. If the breakaway gap occurs on light volume, a position might be entered on a pullback. In the final analjsis, if the breakout represents a major change, a frade should be entered immediately at the market price. The poor executions will be offset by a single time when prices move quickly and no pullback occurs. A breakaway gap on high volume should he more indicative of such a major change.

Many traders believe that prices will retrace and -fill the gap" that occurred sometime earlier. There are analjsis who never give up, but waiting to fill a gap that is more than two years old may be carrjing this technique too far. There is no doubt that the gap represents an important point at which prices move out of their previous pattem and begin a new phase. The breakaway gap will often be a position just above the previous normal price level. Once the short-term demand situation has passed, prices should rdum to near normal (perhaps slightly above the old prices), bul also slightly below the gap.

KEY REA-ERSAL DAYS

A formation that has been endowed with great forecasting power is the key reversal day, sometimes called an outside reversal day. It is a weaker form of an island reversal. A bearish key reversal is formed in one day by first making a new high in an upward frend, reversing to make a low that is lower than the previous low, and then closing below the previous close. It is considered more reliable when the prior frend is well established. This could be identified using EasjLanguage as

KeyReversalDown = 0,

(fflif close[l] := (aaverage(close[l],n) andhigh := (ahighest(high[l],n) and low < low[l] and close < close[l] then KeyReversalDown = 1;

where the first term tests for an upfrend over n-dajs, the second tests that this day is the highest price of the same n-dajs, the third verifies a lower low, and the last tests a lower close.

Studies have shown mixed results using the key reversal as a sole trading indicator. The most complete analjsis, similar to others, concluded that the performance was Strikingly unimpressive." Even though tests have not proved its importance, fraders still pay close attention to key reversals. Based on this, it must be concluded that other fadors unconsciously enter into the normal perception of a key reversal. A traders senses should not be

0 Erie Evans, "Wliy You Cant Rely ou T.ey I eversal Days," Futures .M.*cl, 19E "

underestimated; the extent and apeed of the prior frend, a change in liquidity, a quieter tone, or some external news may be essential in confirming the important reversals.

Pivot Point Reversals and Swings

A prvot point is a trading day, or a price bar, that is higher or lower than the bars that come before and after. It is the common form of an island reversal and a popular way of identifjing turning points. The most frequent pivot point high is a bar that has a higher high than one day before and one day after. More significant swing highs can be found by comparing the high of any day with two or more dajs before and after. This is the method used in TradeStations "Swing High Bar" fundion. The pattem of the dajs on either side of the high bar are not important as long as the middle bar has the highest high

Pivot points are used as the basis for finding swing highs and lows, and they identifj the exfremes of both price and oscillator for TradeStations divergence fundions. For exanple, if the last two price pivot points correspond to the same dajs as the last two stochastic or RSI pivot points, and prices are rising while the momentum is falling, there is a bearish divergence. When more dajs are used to identifj pivot points, these diveigence signals are expected to be more

significant; unfortunately, they take longer to identifj. Cups and Caps

Another name given to the pivot point reversals are cups and caps, each determined by only three price bar These two formations are associated with trading rules that are identical to pivot point channels applied to the shortesl time frame. Contrary to their names, a cup formation identifies a sell signal when the frend is up, while a cap is a setup for a buy signal in a downfrend. Once an upfrend is clear, a cup formation is found using either the daily closes or daily lows. For any 3 consecutive dajs, the middle day must have the lowest close or the lowest low. In a cap pattem the middle day must have the highest high or the highest close of the 3-day cluster. In both cases, the positioning of the highs and lows of the other 2 dajs are not important as long as the middle day is lower for the cup and higher for the cap.

The cup will generate a sell signal if.

1. The cup formation is the highest point of the upfrend.

2. The sell signal occurs within 3 dajs of the cup formation.

3. The current price closes below the lowest low (middle bar) of the cup formation.

The signal is false if prices reverse and close above the high of the cup formation, resuming the previous frend. This pattem is only expected to forecast a downward price move of two dajs; however, every change of direction musl start somewhere, and this formation could offer an edge. A cap formation is traded with the opposite rules.

According to tests by Colby and Meyers," enfries that occur based on a breakout of the highs or lows of the pivot points, called pivot point channels, are much more reliable than simply entering in the direction of the reversal based on the close of the last bar of the pivot point, cup, or cap formation. For traders not interested in this very short-term strategj, a pivot point may help entrj timing for any longer-term method.

EPISODIC PATTERNS

There is litde argument that prices change quickly in response to unexpeaed news. The transition from one major level to another is termed an episodic pattem; when these tran

an be f. .uud in I .bert wf Colby and Th. Jiias A Meyer.-, The Encyclopedia .f TecLuical M.*ket bdic* ts 228

sitions are violent, they are called shocks. The coffee and oil markets have received the greatest number of shods; however, all markets are continually adjusting to new price Icyels, and all experience occasional shods.

The pattem that results from episodic movement is exactly what one might expect. Following the sha price movement there is a period when volatility declines fran its highs, narrowing until a normal volatility level is found and remains at that level (Figure 94).

Pattems that result from rising prices are not the same as falling prices. Although higher price moves usually overshoot the price level at which they normally settle, sha declines do not reach their final levels during the firsl shock.

Price shods have become the focus of much analytic work. Because a price shock is an unpredictable event, il cannot be forecast. This has a critical effect on the way in which sjstems are developed, especially with regard to the testing procedures. This topic is covered in other parts of this book under the topics "Price Shocks," "Robushiess," and "Optimization."

PRICE OBJECTIATS FOR BAR CHARTING

There is some satisfaction in having a price objective for a trade that has just been entered, if this objective can be determined to a reliable degree, those frades would be selected that have the best profit potential as compared with the risk. It is also comforting to know that profits will be banked at a apecific point. The most successful objectives will be based on straightforward concepts and not complex calculations.

The simplest and most logical price objective is a major support or resistance level established by previous frading. When entering a long position, look at the most welldefined resistance levels above the entry point. These have

been discussed in a previous section of tliis chapter, "Tops and Bottoms." When those prior levels are tested, there is generally a technical adjushnent or a reversal. In the case of a strong upward maiket, volatility often causes a short penetration before the setback occurs. Placing the price objective a reasonable distance below the identifiable major resistance level will ahvajs be safe; the intermediate resistance levels can be used for adding positions on technical reversals. The downside objective can be identified in a similar manner: Find the major support level and place a stop just above it.

FIGURE 9-4 Episodic pattems. (a) Upward price shocks, (b) Downward price shocks.

When using both support and resistance price objectives, watch carefiilly for a violation of the current trend-dont be rigid about the position. Take advantage of each reaction to add to the position, but get out if the major trendline is broken before the objective is reached. On the other hand, if the goal is reached and prices react as predicted but then reverse and break through the previous highs or lows, the trade may be reentered on the breakout and a new price objective calculated.

There are other, more analytic wajs to ddermine the objective of a trade. Bear in mind that these methods are considered guidelines and are not precise, if you have set a single price taiget for a long position, and it falls slightly above a resistance level, then the resistance level (the closer point) should be subatituted for an original price objective.

The head-and-shoulders top has a downside objective that is associated with its volatility. This objective is measured from the point where the right shoulder penetrates the neckline and is equal to the distance fran ttie top of the head to the neckline (Figure 9-5). For a major top, this goal seems modest, but it will be a good measure of the initial reaction and will generally be safe, even if a new high price is reached later.

For a consolidation area, both top and bottom, a counting method based on the width of the rectangle or consolidation pattem is used to find the price taiget. For a basing formation, the objective is the vertical distance above the support line equal to the width of the consolidation area (Figure 9-6). For downside objectives, measure vertically downward fran the resistance line forming the upper bound of the congestion area, a goal similar to the head-and-shoulders top. This technique implies that the longer the consolidation area, the bigger the subsequent breakout. The same method can be seen later in point-and-figure charting.

Trendlines can also be used to measure the expected price move. The most common techniques are based on channel volatility and, therefore, set very modest, realiatic targets.

I. The channel width, which bounds a trend, will be equal to the price objeaive measured from the point of the channel breakout (Figure 9-7).

FIGURE 9-5 Head-and-shoulders top price objective.