Descending Broadening Formations: Identifying Key Trends
The descending broadening formation is a technical analysis chart pattern that signals market indecision and potential trend reversals. It occurs when prices make progressively lower lows and lower highs, expanding the price range over time. This pattern resembles a megaphone that widens as price action continues. Unlike ascending broadening formations, descending formations point to bearish market sentiment, with the breakout typically occurring in a downward direction.
Key Characteristics of Descending Broadening Formations
To properly identify a descending broadening formation, it is essential to look for several specific characteristics:
- Lower Highs: The upper trendline of the pattern slopes downward, indicating that each price peak is lower than the last.
- Lower Lows: Similarly, the lower trendline also slopes downward, showing that each price trough is lower than the previous one.
- Expanding Price Range: The distance between the highs and lows increases over time, creating a widening pattern that resembles a megaphone.
- Multiple Touch Points: There should be at least two lower highs and two lower lows touching their respective trendlines for the pattern to be valid.
Formation Process
The descending broadening formation is typically formed during periods of heightened volatility and market uncertainty. Sellers dominate the market, causing prices to make lower lows, while occasional buyer strength creates lower highs. The result is an expanding price pattern, with each successive move pushing the limits of the previous price action.
In many cases, the pattern is a continuation of a downtrend, with the breakout happening to the downside. However, in some instances, the pattern can signal a reversal, with prices breaking out upwards, leading to a bullish reversal.
Trading the Descending Broadening Formation
1. Identifying the Breakout
The breakout is the key moment for traders looking to profit from the descending broadening formation. While the pattern usually breaks downward, signaling a bearish continuation, it is essential to wait for confirmation. A downward breakout occurs when the price closes below the lowest low in the pattern, often accompanied by an increase in volume. Conversely, if the price breaks upward through the upper trendline, it could indicate a reversal.
2. Target Price Calculation
The measure rule is used to calculate the target price after the breakout. This involves measuring the height of the pattern from the highest high to the lowest low, and then subtracting this height from the breakout point (for a downward breakout). If the breakout is upward, the height is added to the breakout level.
For example, if the highest high in the pattern is $100, and the lowest low is $80, the height of the pattern is $20. If the breakout occurs at $80, the target price for a downward breakout would be $60.
3. Stop Loss Placement
Risk management is critical when trading descending broadening formations. Traders typically place stop-loss orders just above the most recent lower high if expecting a downward breakout. This minimizes losses in case the price reverses and breaks out upward.
Performance Statistics
Descending broadening formations can have varying performance depending on market conditions. Here are some important performance metrics:
- Average Decline after Downward Breakout: 18% in bear markets
- Failure Rate: 9% in bull markets, 16% in bear markets
- Average Time to Target: Typically within 2 months after breakout
These statistics highlight the effectiveness of trading in the direction of the prevailing trend. In bear markets, descending broadening formations tend to result in stronger downward moves compared to bull markets.
Common Mistakes to Avoid
While descending broadening formations can be profitable, traders should be aware of common mistakes that could lead to losses:
- Entering Too Early: Prematurely entering a trade before the breakout is confirmed can lead to losses if the price reverses direction. Always wait for confirmation of the breakout before placing a trade.
- Ignoring Volume: A breakout without an increase in volume may be a false signal. Traders should always confirm breakouts with rising volume.
- Failure to Use Stop-Loss Orders: Trading without a stop-loss exposes traders to significant losses if the pattern fails. Always use a stop-loss to protect your capital.
FAQs About Descending Broadening Formations
1. Is a descending broadening formation bullish or bearish?
Descending broadening formations are typically considered bearish continuation patterns, as they often form during downtrends and signal further declines. However, they can also act as reversal patterns if the price breaks upward, though this is less common.
2. How can I confirm a breakout from a descending broadening formation?
A downward breakout is confirmed when the price closes below the lowest low in the pattern, usually accompanied by increased volume. For an upward breakout, confirmation occurs when the price breaks above the upper trendline with rising volume.
3. What time frame is best for identifying descending broadening formations?
Descending broadening formations can be identified on various time frames, from intraday charts to daily and weekly charts. The best time frame depends on your trading strategy and goals, but the pattern is more reliable on longer-term charts such as daily or weekly charts.
4. Can a descending broadening formation signal a bullish reversal?
While it is primarily a bearish pattern, a descending broadening formation can occasionally signal a bullish reversal if the price breaks upward through the upper trendline. However, this is less common, and traders should wait for confirmation before trading a reversal.
5. How do I calculate the target price after a breakout?
The target price is calculated by measuring the height of the pattern (the distance between the highest high and the lowest low) and applying it to the breakout point. For downward breakouts, subtract the height from the breakout price; for upward breakouts, add the height to the breakout price.
6. What should I do if a throwback occurs after a breakout?
A throwback happens when the price briefly retraces to the breakout level after a breakout. If this occurs, monitor the price action closely. As long as the price stays below (or above, in the case of an upward breakout) the breakout level and volume remains strong, the breakout may still be valid.
Conclusion
Descending broadening formations offer traders valuable insights into potential market movements. By identifying the key characteristics, waiting for breakout confirmation, and applying sound risk management strategies, traders can effectively trade this pattern. However, as with any chart pattern, it's crucial to avoid common mistakes like premature entries and ignoring volume signals to ensure successful trades.