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The most difficult aspect of technical analysis, and the part that must be mastered in order to be a successful trader, is consistent price pattern identification.
There are a number of chart formations that recur with enough statistical frequency that technicians are able to rely on them to predict future price action. Nothing is certain, of course, but chartists play the odds as well as anyone. Protected with appropriate hedges and stop-loss arrangements, trading price patterns can be turned into a very lucrative affair.
Some chart patterns are considered “reversal” patterns, while others are referred to as “continuation” patterns. Today, we’re going to examine several of these formations with an eye to those that are indicative of price reversals.
1. Head-and-Shoulders Pattern
To begin, head-and-shoulders patterns come in two varieties: those that signal market tops and those that signal bottoms (known as “reverse head-and-shoulders” patterns).
They look like this:
On the chart above, the left shoulder is formed from October through December, the head between January and February and the right shoulder from March to April. The “neckline” (in blue) joins the shoulders and extends beyond the right shoulder. Once the price breaks below the neckline (green dot), the formation becomes “official,” and the selling generally comes fast and furious until the full downside “count” has been reached.
How to Determine a Post-H&S Downside Count
With enough of these head-and-shoulders (H&S) patterns statistically quantified, it becomes clear that the distance from the top of the head to the neckline generally equals the distance from the neckline to the bottom of the post-H&S decline.
So, in the example above, the fall from the top of the head at 150 to the neckline at 125 (25 points) equals the distance from the neckline down to the target retracement bottom at 100 (125 – 25).
Important trading note: The longer the H&S pattern takes to form, the longer the trend after the reversal is likely to last. Longer-term traders should therefore ignore H&S patterns that are filled over the course of several weeks, as they usually presage a very brief slide in price.
Below is an example of a reverse head-and-shoulders pattern:
As you can see, the same rules that govern the head-and-shoulders top and its neckline counts also apply to the reverse head-and-shoulders pattern, only in the opposite direction.
2. Double and Triple Tops (and Bottoms)
The next reversal pattern that recurs with regularity is the multiple top or bottom. In this case, the stock bumps up against resistance (or down against support) two or three times and then reverses course for good.
Like head-and-shoulders tops and bottoms, the longer the “bumping” period, the greater the likelihood that a long-term change in trend will ensue.
Here’s an example of a triple top:
There’s no particular downside “count” associated with a double or triple top (or bottom), though some traders attempt to use necklines to figure their targets. In my experience, traders might best be served by employing a Fibonacci retracement to calculate an initial downside price target.
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