FINRA Series 3 Free Practice Questions 81

Triangles
Triangles are congestion patterns that can signal either continuation or reversal. They come in three distinct varieties: symmetrical triangles, ascending triangles, and descending triangles. A symmetrical triangle has an upper line that slopes downward (it looks like a
down trendline) and a lower line that slopes upward (it looks like an up trendline). These lines converge at a point. With all congestion patterns, there is a war going on between the bulls and the bears. Within a triangle, the sides are matched fairly evenly, with neither side winning. (See Figure 8.18.) However, at some point, as time goes forward, one side will win. The market will break out of the triangle, and this is the time to act because the breakout signifies the direction of the next major move.
Figure 8.18. Symmetrical triangle The general rule is that the most valid signals will come when the market breaks out prior to reaching the end, termed the apex. The best breakouts generally occur approximately two-thirds of the way along with the length of the triangle. Also, as with most of the other patterns, the volume should increase on the breakout. You know you’re caught in a false move, a “trap,” when the market
trades back into the triangle after the breakout and all bets are off when it moves over to the other side.
Ascending triangles and descending triangles are like their symmetrical brethren, except they work toward a breakout in the direction of their respective names. The ascending variety has a flat upper boundary with a rising lower boundary that can be defined by an up trendline. The bulls are able to support the market at successively higher lows, while the bears are making a stand at the upper resistance level, with the result more likely to be a breakout to the upside. This is generally a continuation pattern, most likely to be seen during a major up
trend. The descending variety is the mirror image, with a lower horizontal support line and successively lower highs that can be connected by a down trendline. Examples shown in Figure 8.19.
Figure 8.19. Ascending (part a) and descending (part b) triangles Volume characteristics match the other patterns; many times, the volume will
jump on the breakout. The bigger the triangle, the bigger the move to follow is likely to be.

Gaps
A gap occurs when a commodity opens at a price higher than the high of the previous day or lower than the low of the previous day. By definition, the gap remains intact if it’s not “filled” during the trading session. In other words, on a “gap-up day,” the market never traded low enough to equal or exceed the high of the previous day on the downside. On a “gap down day,” the market was never able to trade high enough to equal or exceed the low of the previous day on the upside. Gaps can be identified fairly easily on a daily bar chart. The trick is to determine which of the four—common, breakaway, measuring, or exhaustion—you are looking at.

Common gaps: The majority of gaps are more likely to be filled sooner than later. Most daily gaps are filled during the same trading session, and of those that aren’t, more often than not, they are filled within a day or two. Because these are the most common variety, they are known as common gaps. They might occur, for example, as a result of a government report, but the news usually is not strong enough to change the major trend, and the gap is filled quickly. Common gaps are seen quite often in thin, or low-volume, markets and are rarely significant. The trick is to be able to differentiate the common variety from the other three. The other three varieties are important technical tools that have powerful forecasting abilities.

Breakaway gaps: A breakaway gap develops at the beginning of a new move. An upside breakaway gap occurs when prices jump up from a bottom, often from some sort of congestion area. A downside breakaway gap occurs when prices jump down from a top, also many times from some
sort of consolidation. A breakaway gap is significant because it signals a change in the supply and demand balance of the market in question. The pressure to push a market to the next level is so great that the market literally has to leapfrog to this new level, effectively trapping many market participants on the wrong side. It is those trapped on the wrong side who will eventually add fuel to this new fire as they liquidate. The shorts trapped under the upside breakaway gap are all holding positions at a loss and will eventually need to find a place to cover. Some of them will hope for a break to cover, but it won’t come. Alternatively, numerous longs will be trapped above the downside breakaway gap, and at some point, they will be selling out. The inevitable result is more downside pressure.
How can you tell a breakaway from a common gap? Common gaps are filled fairly quickly. Breakaway gaps are not filled for a long time,
sometimes never for the life of a contract. They signify the start of a new and major trend move. Many times they form out of consolidation or during blow-off highs or lows. The breakaway day is accompanied by greater-than-normal volume, usually at least 50% greater than the average volume of the preceding two weeks. These are significant and powerful tools that you should be alert for constantly. Particularly, watch for them when a market appears to be “cheap” or “expensive.” The market could be basing for a major bottom or climaxing for a major top. 3.

Measuring gaps: A measuring gap is found at approximately the midpoint of a powerful trend move. Such a gap forms one day, often on news, but unlike with a common gap, the market continues on its way without filling the gap. Once again, volume is usually large. Measuring gaps serve to trap many players who are on the wrong side even more deeply in the muck, and these traders provide some of the fuel for the next leg up or down. The interesting thing about these gaps is that they tend to occur when a move is just about half over. If the breakaway came at 100 and the measuring is at 140, you can project that this move will run to about 180. The measurement rule is certainly not written in stone. At times, there will be more than one measuring-type gap in powerful moves, perhaps one at 33% of the move and another when the move is about 60% to 67%. However, the 50% rule is usually pretty close, so it can help you determine approximately where you are in the move. Exhaustion gaps can do this, too. (See Figure 8.20.)

Exhaustion gaps: An exhaustion gap forms near the end of a move. In a major uptrend, the market gaps up to new highs, generally on bullish
news. In a major down trend, the market gaps down to new lows, perhaps on new bearish news, sometimes based on final panic liquidation. In both cases, many times these gaps follow wide-ranging or limit-type moves. In markets that still have limits, the exhaustion day might even trade at the limit at some point in the direction of the major trend. Unlike with the other gaps, however, this is the beginning of the end. The market has run out of steam, even though most of the participants do not realize it on that day. One way to explain this is that on the day of an upside exhaustion gap, the last of the weak shorts have thrown in the towel and are covering their positions. The last of the “uniformed” longs are entering the party believing this market still has a long way to go. However, the news is always the most bullish at the top, and the market is satiated. High prices are starting to ration demand, and supply is beginning to come out of the woodwork. With a downside exhaustion gap, the last of the under margined longs have given up. Many times, panicky conditions prevail as the red ink flows. This, too, is the beginning of the end because low prices have begun to stimulate demand.

How can you determine whether a gap is of the exhaustion variety? Unlike with breakaway or measuring gaps, an exhaustion gap will be filled fairly quickly. More commonly, the market will churn for three to five days, but it will generally be filled fairly quickly—sometimes the next day. Many times, the high of the exhaustion top day will not be exceeded, or with a downside, there will be no lower lows. The volume will be high, but it was probably high in the days preceding the exhaustion day, too. Like breakaway gaps, exhaustion gaps are powerful indicators. Keep your exhaustion gap antenna up when a market becomes wild-eyed after a long run-up or panic-stricken after a long run down. Remember, it is always darkest before the dawn and brightest just before the sun starts to recede.

Finally, no discussion of gaps is complete without mentioning the island formation. Islands can be formed in part by either exhaustion or breakaway gaps. An island bottom is formed by a gap down, price action at a basing level, and then a breakaway gap up. An island top is formed by a continuation of exhaustion gap up, some price action at new highs, and then a breakaway type gap down (or vice versa). Islands are easy to spot because they look like islands in the sky (or the sea). They are rare but powerful, and you’ll know one when you see it! Figure 8.21 is a daily cocoa chart illustrating examples of each variety, all occurring within a two month time period.

Five rules for trading gaps
The following are five useful rules for successful gap trading:
1. The majority of gaps are common and will be filled. Do not look for significant gaps at nonsignificant times. If market gaps on minor news, low volume, or what doesn’t appear to be a major top or bottom, assume that it will be filled. Scalpers can fade these common gaps and look to take profits when they’re filled. If a gap is not filled fairly quickly (within two to seven trading days), begin to treat it as a significant gap (either a breakaway, measuring, or exhaustion gap—depending on where the market is in its cycle).
2. When a market is forming a long base, place a buy stop above the base to catch a breakaway-type move. Many times, breakaway gaps occur when they’re least expected; at times, they occur on no news. I’ve observed on breakaway-up days that the lows are generally registered right at the open. If you are stopped into a new long position in this way, place your sell stop at the low end (the fill) of the gap. If it is any good, it should not be filled, and you should be in close to the lows for maximum potential profitability.
3. Measuring gaps offer an excellent opportunity to pyramid a position. If you spot a measuring gap and are already in on a base position, it is time to double up and move your stop loss on the entire position to the fill of the measuring gap. Your average price is better than the market, and your risk on the new “add” is minor. When they work, you have a lot of profit potential remaining on the new, larger position.
4. Never anticipate exhaustion gaps—wait for them to be filled to take a new position. Exhaustion gaps occur in the final stages of a major move. This phase is almost always volatile, and it is extremely difficult to pick a top or bottom. It is only after the exhaustion gap is filled that you can define what your risk is and what it truly was exhaustion. I have seen occasions when the bullish sentiment is so frothy that it forms exhaustion but still can work higher for days or weeks before it’s filled.
5. When you see a significant gap (a breakaway, measuring, or exhaustion gap), act! This is not the time to hesitate; it is the time to act aggressively. Just do it! If you wait, you’ll be left holding the bag. Significant gaps generally offer a good reward to risk because you can define fairly closely what your risk should be.

I’ve identified three major volume rules:
1. In a major uptrend, the volume will tend to be relatively higher on rallies and lower on declines or trading ranges (consolidations).
2. In a major downtrend, volume will tend to be relatively higher on declines and lower on rallies or trading ranges (consolidations).
3. Volume will tend to expand dramatically at major tops and bottoms. Major bottoms can be characterized by climax-type selling. Blow-off tops will be associated with climatic volume, too.