In our previous two ETF Authority issues, I used this educational bonus section to cover the head and shoulders pattern, as well as rounded tops and bottoms, and double and triple tops and bottoms. This week's topics are spike reversals and wedges. After this week's lesson you will be able to recognize all of the major reversal patterns.

SPIKE ("V") TOPS AND BOTTOMS
Unlike other reversal patterns, it is often very difficult to forecast spike tops or bottoms. In fact, unless you are basing your work on volatility studies, seasonals, or forward-looking techniques such as Elliott Wave or cycles, you will almost never be able to predict spike moves ahead of the fact. However, after reading this section you will know exactly what action to take when they do indeed occur.

I am not going to spend time trying to show you how to predict spike reversals in this section. Spike reversals occur largely because they are difficult to forecast, and the methods used to predict them are extremely complex. In later lessons I will cover some of those methods, which may help you prepare for just such possibilities in the future. However, in today's lesson I'm going to focus on how to effectively trade spike reversals shortly after they take place.

ARE THERE PERIODS WHEN SPIKE REVERSALS ARE MORE LIKELY THAN OTHERS?
The answer to that question is yes. For example, historically the stock market has tended to go through periods of extreme volatility during the months of September and October. Many commodity markets tend to make spike reversals during certain calendar periods as well (Natural Gas often turns in November and March, for example). In addition, major fundamental surprises can turn a market on a dime at just about any point in the year.

Many market technicians were rightly concerned that the equity markets could crash back in August and September 2001. Volatility was expanding. Volume was strong, even over the summer. Everybody was getting short. At that time I warned my clients of risk of a huge downward move in U.S. equities. I certainly did not predict the cause of the final huge move lower -- the terrorist attacks of September 11th, 2001 -- but the markets may have collapsed even without that heinous event. We will never know.

Two other recent examples of spike reversals took place during the Asian currency crisis of 1997 and the Russian debt and Long Term Capital Management (LTCM) induced market move in 1998. Both of these factors led to major drops in stocks, but were subsequently followed by enormous and powerful reversals higher. In the case of LTCM, the event also resulted in a V-top in the bond market and in the dollar versus the yen.

WHICH ARE MORE COMMON, V-TOPS OR V-BOTTOMS?
I asked the above question for a reason. If you've read a variety of basic technical analysis texts, then you've probably seen statements that say that markets produce V-Tops, but rarely ever produce V-Bottoms. There's a simple reason for this. At V-Tops, once everybody is long, there is no place to go but down. However, at the end of a long bear market, there is little interest in the asset under question. Therefore, it generally takes a long time to build up confidence, leading to protracted trading ranges and rounded bottoms.

In recent years, there has been a great deal of focus on spike bottoms in the stock market. We've seen many of these in recent history, and most of them have occurred amidst the framework of a larger bull market. The one exception to this was last year's bottom. However, last year's lows, though they represented the start of a powerful rally, were also a double bottom.

Additionally, bull corrections within bear markets are typically large and powerful. In my opinion, the bear market that began in 2000 is not yet over. When the market reaches a final bottom, which I believe it has not yet done, the major indices will likely form a large base before the next major secular multi-year or generational bull market starts.

RECOGNIZING AND TRADING SPIKE REVERSALS
I almost do not need to write this section, as spike reversals are so obvious to identify on a chart. They are almost always a key reversal (see our educational bonus section in our August 11, 2003 for an explanation of key reversals). When spike reversals take place, volume should be strong (though trading halts can affect this). Volatility, measured both in historical terms as well as by implied volatilities in the options markets, also usually jumps. In the case of the stock market, we typically look for volume breadth to be 90% up or down on one of these days. (This means in a V-Top, 90% of all shares traded will be in securities that traded up. In the case of a V-Bottom, 90% of all shares traded will be in securities that traded down.) Price and volume should follow through strongly (although volume is not typically as high as in the run-up prior to the reversal) in the opposite direction. Breakaway gaps (see our educational section from our July 28th, 2003 and August 4th, 2003 ETF Authority issues) are common as well following the V-reversal day.

After a V-reversal has taken place, we almost always see a retest to the old trend. You can safely buy into such moves (buy on a retest of a V-Bottom, or sell into a retest of a V-Top) as long as volume is lower on the retest. In these cases, a good place to put your stop losses is just beyond the old extreme.

"SO, STEVEN," YOU MAY ASK, "WHY DO YOU CALL IT A REVERSAL PATTERN?"
I'm really glad you asked me that question! The answer is very simple: Wedges usually occur at the end of a trend. By the time you recognize that you are in a wedge, you will be far enough along in it to realize that the old active trend is probably running out of steam.

THE ELLIOTT WAVE CONNECTION
In my favorite book on using Elliott Wave, "Applying Elliott Wave Theory Profitably" (written by yours truly), I discuss the wedge pattern in great detail. Wedges have another name in Elliott Wave theory -- the diagonal triangle (some call it a terminal triangle). Diagonal triangles take place at the end of a full Elliott Wave pattern, either in Wave-5 or Wave-C. These waves always take place at the end of an active price cycle.

WHAT DOES A WEDGE LOOK LIKE?
Wedges can be subdivided into two different types: Rising wedges and falling wedges. A rising wedge, which usually comes at the end of an uptrend, is a bearish signal. It combines an up trendline with a resistance line (drawn across high prices) that is also rising, but is converging with the up trendline. A falling wedge, which is bullish, combines a down trendline with a downward-sloping (but converging) support line.

The following example of a rising wedge (diagonal triangle) is taken from my book:

BE CAREFUL OUT THERE
Once you learn about wedges, you're probably going to start seeing them everyplace you look. Please understand that they do not occur all over the place. Although they might show up even on intraday charts (in the proper place in Elliott Wave terms), the classic technical analysis wedge takes at least a couple of weeks to develop. Of course, wedges can also develop in much longer timeframes as well (weekly, monthly or longer).

The pattern appears as a five-point reversal. What I mean by five points is that from its start (see the "4" in the graph above), there should be five line touches -- three on the resistance line (in a downtrend, it would be the support line) and two on the active trendline. A break of the trendline confirms the pattern has ended. The minimum target following such a pattern -- using the Elliott Wave definition, which I prefer -- is for a return to the point where the pattern started (in the example above, point "4").

Again, when examining a wedge you need to ensure that there is a trend to reverse. If there was no trend to begin with, then there can be no reversal. (This is true of all reversal patterns, of course.) I also like to see momentum divergences as well as falling volume as the pattern develops. In addition, if we are looking at futures, then I want to see falling open interest. The break of the trendline should occur on increasing volume and momentum (in Elliott Wave terms this often happens in five waves).

STRATEGY
You must exhibit great care when attempting to trade a wedge. False breakouts are common. For example, look at the chart of the Japanese Nikkei (shown below) as it bottomed in April 2003 and May 2003. At both nadirs, there was little follow through lower. Another hint that a bottom was near came from volume: It remained strong in April when prices moved higher after the initial break. Moreover, in May, the low was made on lower volume than the April bottom. Although not shown, there were yawning momentum divergences at both lows. In a case like this one, the safest strategy is to buy on the break past the trendline and to place your stops beneath the lows to date.

Good trading!

Steven Poser
Editor
The ETF Authority
New York, NY