There are a number of reversal patterns that playout time and time again. The most reliable of the reversal patterns is the "Head & Shoulders" top and bottom. Some technicians don't like to use the term head & shoulders as it's used quite a bit and not all reversal patterns are confirmed and end end up being consolidation patterns instead. Whatever you like to call the pattern is irrelevant. What is important is that you can identify the pattern as it signals possible distribution and reversal of the prior trend.
Some Background on Chart Patterns:
Charles Dow first introduced Dow Theory in his writings in the Wall Street Journal well over 100 years ago. Dow Theory is the origin of trend following. In 1948 Edwards and Magee introduced Technical Analysis of Stock Trends. This book expanded on the work done by Dow and introduced chart patterns as a system to identify changes to the existing trend. In 1997 John J. Murphy introduced Technical Analysis of the Financial Markets which is considered by many to be the definitive work on trend analysis and chart patterns first introduced by Dow and refined by Edwards and Magee. If you're not familiar with these works I highly suggest looking into each.
Identifying the Pattern:
1) There must be a trend in place. If the H&S pattern is a topping pattern then the prior trend must be an uptrend. If the H&S pattern is reversed and is a bottoming pattern then the prior trend must be a down trend.
2) As the pattern unfolds and the peaks are formed, a clearly defined support line called the neckline must be present.
3) Volume will confirm the pattern. Volume should be decreasing at the peak of each point in the left shoulder, head, and right shoulder.
Confirming the Pattern:
1) The existing trendline is broken.
2) The neckline is broken.
3) The neckline will now act as resistance. (Often, but not always the price will try to reclaim the neckline shortly after breaking.)
The Pattern is Invalid:
1) If volume is not receding at each peak then the technician should be skeptical of the validity of the pattern.
2) The right and left shoulder should be similar in height. Often times they are not, if in doubt use volume as your indicator.
3) Either the neckline or the prior trendline is retaken as support.
Forecasting a Price Target:
Using the measured move technique, the distance from the peak of the head to the neckline can be forecasted from the spot of the neckline being broken downwards. This distance can be used as a minimum downside price target.
Example:
This is an Apple Daily Line Chart from November 2020 to March 2021. All the important elements of a Head and Shoulders Reversal Pattern are evident.
1) A prior trend was in place.
2) The formation of the left shoulder, head, and right shoulder.
3) Retreating volume at each peak.
4) Breaking of the trendline.
5) Breaking of the Neckline.
6) Price tries to recapture the Neckline but fails.
7) Minimum downside target is reached.
Conclusion:
Pattern recognition is as much of an art form as it is a science. As technicians we want to draw our lines with fat crayons vs thin pencils. Patterns don't always follow the text books. The key is to understand the main tenants of each pattern and try to spot their formations before they confirm.
Thanks for taking the time to read this. Good luck to all!
Some Background on Chart Patterns:
Charles Dow first introduced Dow Theory in his writings in the Wall Street Journal well over 100 years ago. Dow Theory is the origin of trend following. In 1948 Edwards and Magee introduced Technical Analysis of Stock Trends. This book expanded on the work done by Dow and introduced chart patterns as a system to identify changes to the existing trend. In 1997 John J. Murphy introduced Technical Analysis of the Financial Markets which is considered by many to be the definitive work on trend analysis and chart patterns first introduced by Dow and refined by Edwards and Magee. If you're not familiar with these works I highly suggest looking into each.
Identifying the Pattern:
1) There must be a trend in place. If the H&S pattern is a topping pattern then the prior trend must be an uptrend. If the H&S pattern is reversed and is a bottoming pattern then the prior trend must be a down trend.
2) As the pattern unfolds and the peaks are formed, a clearly defined support line called the neckline must be present.
3) Volume will confirm the pattern. Volume should be decreasing at the peak of each point in the left shoulder, head, and right shoulder.
Confirming the Pattern:
1) The existing trendline is broken.
2) The neckline is broken.
3) The neckline will now act as resistance. (Often, but not always the price will try to reclaim the neckline shortly after breaking.)
The Pattern is Invalid:
1) If volume is not receding at each peak then the technician should be skeptical of the validity of the pattern.
2) The right and left shoulder should be similar in height. Often times they are not, if in doubt use volume as your indicator.
3) Either the neckline or the prior trendline is retaken as support.
Forecasting a Price Target:
Using the measured move technique, the distance from the peak of the head to the neckline can be forecasted from the spot of the neckline being broken downwards. This distance can be used as a minimum downside price target.
Example:
This is an Apple Daily Line Chart from November 2020 to March 2021. All the important elements of a Head and Shoulders Reversal Pattern are evident.
1) A prior trend was in place.
2) The formation of the left shoulder, head, and right shoulder.
3) Retreating volume at each peak.
4) Breaking of the trendline.
5) Breaking of the Neckline.
6) Price tries to recapture the Neckline but fails.
7) Minimum downside target is reached.
Conclusion:
Pattern recognition is as much of an art form as it is a science. As technicians we want to draw our lines with fat crayons vs thin pencils. Patterns don't always follow the text books. The key is to understand the main tenants of each pattern and try to spot their formations before they confirm.
Thanks for taking the time to read this. Good luck to all!