Broadening Formation Unfolds on Major US Indexes

Dec 1, 2007: 1:48 PM CST

As mentioned previously, the classic technical analysis pattern of the “Broadening Formation” has formed on the Dow Jones Index, which has historically bearish implications.

Before we look at the charts, let’s define “Broadening Formation:”

Quote From Investopedia:

“A pattern used in technical analysis to predict the likelihood of a reversal in the direction of the current trend. It is identified by finding diverging trendlines that connect a series of widening peaks and troughs. The most common type of broadening formation is found at the end of a prolonged uptrend and is used to predict a move lower.

As the two trendlines diverge from the apex, the pattern resembles a reversed version of a symmetrical triangle. This pattern is considered quite rare, but the signal it generates is deemed to be very reliable.”

The default chart they use to define the pattern looks like this:

For more specific information, consult Thomas Bulkowski’s Encyclopedia of Chart Formations or Edwards and Magee’s classic text Technical Analysis of Stock Trends.

Broadening formations often represent struggles between large buyers and sellers and frequently represent inherent indecision in the market place. They may also represent large-scale campaigns of distribution by large funds as price swings unstably as volatility increases. It can almost ‘feel’ like those who are struggling to find balance in the market are slowly losing it with each price swing and eventually the system – stability – breaks down.

Let’s see if these definitions apply to the current market:

Weekly bar chart:

Notice the rampant increase in volume during the broadening formation pattern.

Not surprisingly, the S&P 500 Index is showing a similar pattern:

The NASDAQ is actually not showing a classic broadening formation, but is showing a sort of ‘backwards’ rising wedge pattern.

The rising wedge concept is detailed very nicely at StockCharts.com. Keep in mind this is a backwards version, which is more akin to the broadening formation.

The NASDAQ chart is still showing a broadening formation.

While patterns do not move stock prices, people do, patterns are actually representative of people’s (and funds’) actions in the market. Patterns are expected to capture the inherent psychology of market participants, and these patterns have been identified and tested through the years. No pattern is ever 100%, but arming yourself with as much information to make a decision as possible frequently is the best course of action.

Whether or not these patters resolve as the ‘textbooks’ indicate they should is to be determined, but at the very least (if you do not take bearish positions now) it is likely worth your while not to be initiating extremely large long positions that you hope will carry out for the next few years if these patterns do resolve as the textbooks would have us believe.

Be careful.

 

 

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