Broadening top explained

WHEN YOU SEE A BROADENING TOP,
THE MARKET WILL EVENTUALLY DROP

Major reversals in trend--those that mark the turn from a bull to a bear market--can take the shape of many price patterns. Stocks or markets can top by creating, for example, head and shoulders or descending triangles. One of the most difficult patterns to predict, however, is the broadening top.

A broadening top is hard for the swing trader to spot because it is seen far less frequently than other important price patterns. It can be visualized, however, as opposite to a symmetrical triangle. Whereas the symmetrical triangle consists of two lines that converge, the trendlines of the broadening top instead diverge. The shape that best captures this pattern is that of a megaphone.

The classic technical analysis text by Edwards and Magee characterizes a broadening top as a market that lacks intelligent sponsorship. It is one in which the public is being whipped around and driven this way and that by rumors. As such, volume during the broadening top pattern tends to be irregular. During some rallies volume may expand, but during others it tends to be tepid. The same pattern applies on pullbacks. Because it is so unpredictable, the broadening top pattern is extremely difficult to trade. There is no clear breakout to either the upside or downside edge of the pattern.

Below you will find a chart of the S&P 500. I have included the 150-day moving average to show that prices have gone below this key measure but have now popped back above it. Within the context of a broadening top, the S&P could reach a marginal new high of say 1170 without changing this pattern's interpretation.

What would cause me to reject the broadening top interpretation? First, the S&P would have to break out above 1163. Second, it would have to hold the breakout level on a pullback. And third, it would need to reestablish an uptrend by making a series of highs lows and higher highs.

Such behavior would keep the index above a rising 150-day moving average and would turn the March-May pattern of lower lows into an aberration. Time will tell if the buying power remains to re-ignite this kind of bull market. Until proven otherwise, however, the broadening top explains the market's current choppy action.

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