Originally published by guppytraders.com
One of the most powerful and reliable chart patterns is the head and shoulder pattern. This signals a trend reversal. The pattern usually takes several weeks, or with an index market, several months to develop and is best seen on a weekly chart.. Once confirmed the pattern is used to set downside targets which have a high level of reliability. These targets are reached in around 80% of occurrences, and often exceeded and that’s bad news for investors in US markets and ultimately in our home markets.
Let’s start with the classic and perfect head and shoulder pattern. It starts with a long term uptrend that peaks and develops a retracement. The retracement is significant enough to be traded as a new downtrend. The retreat often breaks below an existing long term trend line.
This is at the end of a strong long term uptrend, so buyers come back into the market, buying on temporary rend weakness. Their buying creates a new rally, and also confirms the development of the left shoulder of the pattern.
This is the activity in 2018 January shown as point 1 on the Dow chart.
The rally rebound is often quite strong and moved higher than the peak of the previous uptrend.
The key difference in this uptrend continuation is when the second rally hits a new peak high and then collapses. This index retreat is significant enough to call an end to the recent rally. The index moves below the recent rally trend line and continues falling.
Investors who missed out on buying the first dip come back into the market expecting a new rebound rally. This activity establishes the head in the head and shoulder pattern shown as point 3 on the chart.
The two low points form the base of the neckline of the pattern. However the pattern is missing the right shoulder. This is created with the new rally rebound.
Two features are required to confirm this as a head and shoulder pattern. The first feature is that the peak of the second rally is lower than the peak that forms the head. This is shown as area 3? and will be established by the rally triggered by the 90 day reprieve in the trade war.
The second feature is that the head and shoulder pattern is only confirmed when the index falls below the projected value of the neck line. The value of the neckline has been projected on the Dow chart. A fall below this neck line on a market retreat confirms the head and shoulder pattern.
The two low points in the pattern – the beginning of the first and second rallies – are joined with a single trend line.
A line is drawn down from the top of the head to intersect the neckline. This value, in index points, is then projected below the neckline. This sets the first downside target for the market downtrend.
On the Dow chart this sets a downside target near 21250.
Patterns are rarely perfect so investors look as much compatibility as possible and adjust the probability of reaching the target level accordingly. The pattern has a left and right shoulder formation and a head. In 2008, this pattern developed two right shoulders so investors are alert for a repeat of this pattern in 2018/ 19. The occurrence of two right hand shoulders did not reduce the reliability of the pattern. The head and shoulder pattern is invalidated if the second rally moves higher than the peak of the previous rally – higher than point 2 on the chart.
Daryl Guppy is a leading international financial technical analysis expert and special consultant to Axicorp. Guppy appears regularly on CNBC Asia and is known as "The Chart Man". Disclaimer: Daryl Guppy is not a financial advisor. These notes are for educational purposes only and provide an example of applied technical analysis.