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The Dow's Descending Triangle

08/24/01 02:30:28 PM
by David Penn

Repeated summer tests of support at 102 may signal a breakdown dead ahead in the Dow.

Security:   DIA
Position:   N/A

Recently, I've noted how chart patterns often come in bunches. This may seem counter-intuitive, but in fact it makes a great deal of sense. Too often, an immediate sense of discovery precludes the greater curiosity that can lead to even greater rewards. Thus, when studying a successful breakout from a particular formation, be on guard for the development of another formation that could act as confirmation of an existing trend or warning of an impending reversal.

In fact, looking for chart patterns in bunches is really little more than extending the notion that "the trend is your friend" to the world of pattern recognition. If, after a downside breakout from a top formation, you note a bearish continuation formation and maintain a bearish position, that would be considered "going with the trend" by a trend-follower. In either event, the goal is to figure out ways to remain in winning positions longer. If spotting chart patterns helps you get into good trades, then considering the possible pattern-after-the-pattern may help make good opportunities great ones.

The previous example of this pattern-after-the-pattern was the intermediate H&S top in Time Warner Telecom ("The Taking of Time Warner TLC"), that developed into a descending triangle. The present example considers the Dow Jones Industrial Average (using the DIA as the instrument), which has developed an intermediate descending triangle after breaking out on the downside from a misshapen intermediate head and shoulders top.

This descending triangle nears a downside breakout following three attempts to close beneath 102 this summer.
Graphic provided by: TC2000.com.
 
The intermediate H&S top in the Dow--like similar price patterns in the S&P and the Nasdaq--formed as part of the concluding top of the April Rally. The Dow formation may not have been traded by more exacting traders, who would have been disappointed perhaps by the lack of definition in the left shoulder (the penultimate peak of the April Rally) and not entered the trade. (They would have fared better than those who took advantage of the Nasdaq intermediate H&S top, which featured a major pullback that retraced more than halfway back into the formation.)

Nevertheless, prices did decline in the DJIA from a breakdown point at about 108, an area that has since provided solid resistance to any of the subsequent summer advances. On the support side, the Dow has failed to maintain lows below 102 on four separate occasions since an initial attempt in July. Highs have continued to be lower; the mid-July high is higher than the high at the beginning of August which, in turn, is higher than the mid-August high.

This is a classic descending triangle price action. As a triangle, the pattern could suggest continuation of the prevailing trend, as well as reversal, though it is the triangle's typical appearance as a continuation formation that is most likely the accurate appearance here. The consistency of the lower highs and the repeated testing of support at 102 both point to a descending triangle as the particular type.

Given the current location of price action, a downside breakout in the next two weeks would not be unexpected, and the size of the formation suggests that a downside target of 97 initially.

One caveat to descending triangles, based largely on the experience of TWTC, is that when the support area is vigorously tested, pullbacks into the body of the formation should be expected. This means either setting a wider stop or trying to take profits sooner on a smaller price break. In the case of TWTC, the wider stop proved to be worthwhile, as the pullback penetrated previous support but then swiftly reversed and resumed its descent.



David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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