|Spikes are patterns based on the crowd participation in the marketplace. The more emotional the participation, the greater the possibility that the spike represents a reversal point. A spike reversal in a downtrend has the low well below that of the previous and succeeding trading days. The close should be in the upper part of the range. A spike is a climax in the selling pressure and it is significant after a period of declining prices. Spikes often are printed when news are released. These events affect on the crowd, which reacts nervously. Speculation is also active in these situations. Volume is an important factor when evaluating spikes. Spikes printed on tiny volume, however, are not very significant. The release of negative news can trigger a fast selloff, but suddenly, with the same speed that prices went down, buying returns to raise prices again. The volatility environment is extremely high. Risk management when trading this pattern is very important.|
Following factors are considered as reinforcing:
- A close near the high of the intraday's range
- A long tail
- Heavy volume
- A significant price decline preceding the spike's formation.
The opposite is true for spike highs. See Figure 1.
|FIGURE 1: WY, DAILY. At the end of the long up leg started in July with a low at about $54, prices printed an up gap and a spike.|
|Graphic provided by: TradeStation.|
|Spike patterns can also fail, providing impressive acceleration of prices in an extremely high-volatility environment. If you want to trade this type of pattern you need strong nerves and a clear trading plan.|
It is difficult to quantify the effectiveness of the different trading techniques based on spikes. Analysis is often based on qualitative assessments, which is difficult if not impossible to quantify. Thomas Bulkowski, in his book Encyclopedia Of Chart Patterns, indicates a failure rate of 17% for bullish reversal spikes and of 24% for bearish reversal spikes. Although their average return is acceptable, Bulkowski considers these average returns too low to risk a trade. I personally do not know of any other quantification concerning spikes.
|FIGURE 2: WY, DAILY. The spike has been printed on heavy volume in a highly positive trend contest. Risk when trading these patterns is high.|
|Graphic provided by: TradeStation.|
|In Figure 2, you can see the daily chart of Weyerhaeuser Co., one of the nation's largest producers of lumber and paper products. The stock on December 15 printed a typical spike. Prices gapped up rallying at the open, but at the end of the day, they closed below the open although well up for the day. The stock went up on news released that Deutsche Bank upgraded the stock to "buy" from "hold," raising the price target to $80 from $65. The volume printed is impressive, with more than 14 million shares traded. The average volume is around two million shares. Typical of spikes is the great emotional participation of the public to some news or event. The next day, prices have closed the gap but so far have not managed to move decisively to the downside. If you want to take this trade, first you have to consider that the general trend of the stock is positive; you are trying to spot exactly a trend reversal, which is not at all an easy exercise, although it could be very profitable if correctly identified.|
Second, the volatility environment is high; you have to be ready to deal with high price fluctuations. In this case, the stop-loss would be above the high of the spike should you open a short position. In addition, take into account the possibility of implementing a time stop in case prices have still not started to move to the downside and break out the $69.50 support.
In summary, spikes are a powerful tool in a library of short-term patterns. Risk management is very important because of the volatile environment in which this pattern is printed.
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