What is the Measuring Principle?
The measuring principle allows traders to set a specific minimum price target when trading a stock. This technique works with any well-defined technical analysis pattern, such as a head and shoulders, rectangle or triangle.
How Does the Measuring Principle Work?
To use the measuring principle to calculate the minimum target for an expected share price move, first establish the height of the pattern. For example, let's assume the S&P is showing a potential four-month topping pattern, with a peak at 1295 and clear support at 1245. If support is broken, then the pattern would take the form of a head and shoulders top. Using this example, the simple calculation looks like this:
Difference: 50 points
Once the height of the pattern has been established, either subtract that amount from the broken support level or add it to the level where the stock breaks out above resistance. In this case, the break will be below support, so we will subtract.
Breakout level: 1245
Less: Height of pattern: 50
Minimum Target: 1195
Once this target is established, traders should then determine if it makes sense with the rest of the technical picture. The S&P's major trendline is at 1200, so a break of key support would lead to a pullback to that trendline. The lower Bollinger band is at 1175, so a decline would end above the band. In my mind, this kind of additional reasoning gives further credence to the target.
Why Does the Measuring Principle Matter?
The measuring principle may have no fully logical explanation, yet it works uncannily well in most cases. However, if the market begins to send a different message, then the trader should be prepared to adapt. After all, the measuring principle is just a principle, not a law.