Head & Shoulders Top
A head and shoulders top is a price pattern that allows you to estimate a trend reversal with a target
price. It received its name because it’s made up of three successive market rallies and declines that stop a support level. The middle rally is commonly twice the size as the preceding and secedingrallies. It may be easier to picture the rally as a person standing at a fence and peering over it, where only the person’s head and shoulders are visible.
When looking for a head and shoulders top, you will be analyzing a stock that has been uptrending. This pattern forms at the top of an uptrend and acts as a warning sign to investors that the security’s trend may be ending. An uptrend is commonly defined as higher highs and higher lows. Because the head and shoulders top will have fairly equal lows, investors will see this as a sign that the trend is weakening.
The following will define the structure of a head and shoulders top:
Because the stock is in an uptrend and creating higher highs and higher lows, the head and shoulders pattern will create the left shoulder by establishing a higher high on average or slightly below-average volume. This shoulder will not stand out but look as if the stock is resuming its current uptrend.
Once the high is created, the stock will create a normal retracement, generating a low or a trough. This low will be higher than the previous lows the stock has created in its prevailing uptrend.
•Once the stock bounces off its low after creating the left shoulder, it will continue to move up, creating another higher high that exceeds the high of the left shoulder. This high will typically happen on lower volume, signaling that the prevailing uptrend is lacking conviction from the bulls and the demand for the stock has declined.
As the head hits resistance levels, the stock will pull back once again, creating another trough. This time the stock will fail to make a higher low but will retrace to the levels of the previous trough. The bears will likely begin to increase their position, which will be noticeable when the volume increases during this pullback. At this point we no longer have higher highs and higher lows for an uptrend but have created two equal lows with the two troughs. This is the first sign that our uptrend is changing.
The stock will find support at the head’s trough and will start to bounce and move higher until it makes the third peak. The right shoulder high will move halfway to two-thirds of the way up towards the previous high (head). It will normally find resistance near the same level the security found resistance when it created the left shoulder. The volume will be noticeably decreased during this rally, confirming that the demand for the stock has subsided.
You may be able to draw a horizontal or slightly diagonal trend line connecting the troughs created by the left shoulder and head. This trend line is known as the neckline. As the stock pulls off its highs from the right shoulder, it will drop down to the neckline.
The volume throughout the head and shoulders top will signal that the stock’s supply and demand is changing. It is common to see volume decrease during rallies and increase during sell-offs. This shows that the buyers are slowing down and there isn’t as much momentum behind each subsequent rally.
The confirmation to enter a bearish trade off a head and shoulders top will be when the stock closes below the neckline. Up to this point we do not have a confirmation of the trend reversing but have seen the uptrend changing; meaning that it is slowing down or starting to move sideways. As is common with a broken support level, you can assume that the old support level will now act as new resistance. Once the stock breaks the neckline, it may retrace back to the neckline and use it as resistance before it continues to fall.
There are two common methods for determining a stock price. Their first and most common approach is to measure from the neckline the distance between the top of the head and the neckline and then subtract the distance from the neckline, which will provide a new price target for the stock. The second approach is to double the height of the right shoulder to estimate the price target.
Head and Shoulders Bottom
An inverse head and shoulders pattern is often referred to as a head and shoulders bottom and is a common reversal pattern at the end of a bearish trend. It holds similarities to both the head and shoulders top and a triple-bottom reversal pattern. Understanding its operation can help chart technicians spot significant changes in trend direction. At first glance, it is easy to assume that this pattern is just a head and shoulders pattern on its head, so to speak. However, there are some important differences that add to the bullishness of this pattern.
The first criteria in identifying a possible inverse head and shoulders pattern is a downtrend. This is a stock that has been establishing a series of lower highs and lower lows. This pattern can appear in any time frame, from intraday, daily or even weekly charts. The longer the pattern, the greater the impact the pattern will have on the security.
The following defines the structure of a inverse head and shoulders:
Because the stock is in a downtrend and creating lower highs and lower lows, the inverse head and shoulders pattern will create the left shoulder by establishing a lower low on average or slightly below- average volume. This shoulder will not stand out but look as if the stock is resuming its current downtrend.
Once the high is created, the stock will create a normal relief rally, generating a peak. This peak will be lower than the previous highs the stock has created in its prevailing downtrend.
Once the stock bounces off its high after creating the left shoulder, it will continue to move down, creating another lower low that exceeds the low of the left shoulder. This low will typically happen on lower volume, signaling that the prevailing downtrend is lacking conviction from the bears.
As the head hits support levels, the stock will rally once again, creating another peak. This time the stock will fail to make a lower high but will rally to the levels of the previous peak. The bulls will likely begin to increase their position, which will be noticeable when the volume increases during this rally. At this point we no longer have lower highs and lower lows for a downtrend but have created two equal highs with the two troughs. This is the first sign that our downtrend may be changing.
The stock will find resistance at the head’s peak and will start to bounce and move lower until it makes the third low. The right shoulder trough will move halfway to two-thirds of the way down towards the previous low (head). It will normally find support near the same level the security found support when it created the left shoulder. The volume will be noticeably decreased during this sell-off, confirming that the bears’ conviction is weak.
You may be able to draw a horizontal or slightly diagonal trend line, connecting the peaks created by the left shoulder and head. This trend line is known as the neckline. As the stock pulls off its low from the right shoulder, it will rally to the neckline.
The volume throughout the head and shoulders top will signal that the stock’s supply and demand is changing. It is common to see volume increase during rallies and decrease during sell-offs. This shows that the sellers are slowing down and there isn’t as much momentum behind each subsequent sell-off.
The minimum expected price target is fairly easy to estimate because investors measure the distance from the head to the neckline and add that amount to the neckline. The time taken to form the pattern indicates how long it could take to reach that target. It is more common for this pattern to retest the neckline than its bearish counterpart. The retest can go as low as the right shoulder and still have the pattern be considered valid.
As price fluctuates on a chart, it is common to see it move in a series of highs and lows. Drawing lines to connect the highs to the highs and the lows to the lows over a period of time can help investors identify a trading pattern known as a price channel. This valuable information can then be used to help recognize a security’s current trend as well as estimate when that trend may have changed. To form a good price channel, two lines (primary and secondary (or return) trend lines) are drawn. Below is a description of these lines, and how to estimate the significance of what is seen.
Primary Trend Line
The primary and most important trend line is drawn first. In a bullish market, it will slope upward and act as a floor or support line connecting the major lows in a trend. In a bearish market, it will slope downward and act as a ceiling or resistance line connecting the major highs in a trend. It is the more important line, because a break in the primary trend line indicates that the trend may have changed.
Secondary Trend Line
This trend line, which is often referred to as the return line, is drawn second and usually has the same parallel slope as the primary line. However, the difference is that when price trades near this line, it tends to return to the primary line. Therefore, in a bullish market, it will slope upward and act as a ceiling or resistance line, whereas, in a bearish market, it will slope downward and act as a floor or support line. A break in the secondary line will provide a clue that the trend has accelerated rather than changed.
Trend Line Strength
Trying to make sense of a chart can sometimes be challenging and subjective. Luckily, there are clues to help estimate the strength and significance of these lines. Three of the most important are the number of touches the trend line has received, the length of time passed since the trend line started and the slope of the line.
1.It takes at least two points to draw a line. As you connect a series of highs or lows, the number of times price bounces off your line, the more significant that line becomes.
2.The more time that has passed that your trend line has not been broken, the more significant that line becomes. This ties in with the first principle but can be taken further due to the choices of time frame you can have on a chart. A trend line on a weekly period chart will typically be more significant than a trend line of a daily period.
3.The slope of the line drawn also offers a clue to its strength. To illustrate this, picture three people running down a road. The first is running in a mad sprint. The second is performing a casual jog. The third is struggling to walk. How long can these people keep up their pace? The same question can be asked when drawing a trend line. A 45 degree angle shows a healthy trend. If it is too steep, the trend most likely won’t continue. If it is too flat, the trend’s health is questioned.
A double top price pattern usually marks the end of an uptrend and commonly reverses into a downtrend. This reversal pattern is also called an “M” formation because it resembles the letter “M.” The double top price pattern commonly marks the end of an uptrend. An uptrend is often defined as a series of higher highs and higher lows, warning investors of the changing trend that occurs when the security fails to make a new high. The pattern is complete when the security creates a new lower low. We will break this pattern down by each segment:
The prior trend is always up before a double top formation occurs.
The first high in the pattern doesn’t necessarily appear any different from previous highs in the uptrend.
After bouncing down off the previous high, the following trough will usually appear after the sell-off to the previous low. This sell-off is commonly accompanied by stronger volume as bears attempt to take control of the security.
After support is tested, a rally will occur on light volume and the stock will move up near the same price level as the previous high.
A resistance bounce near the previous high price level will be followed by another sell-off, making two fairly equal highs. The two similar highs create the double top or “M” appearance.
The pattern isn’t complete until the final sell-off results in a lower low. Usually the stock will move below the previous low with greater-than-average volume.
To estimate a price target, subtract the price difference from resistance (top horizontal line) from lower support (bottom horizontal line) of the “M.” Subtract this amount from the support line price to establish a price target.
A double bottom pattern reverses a downtrend to an uptrend. This reversal pattern is also called a “W” formation because the security’s movements resemble the letter “W.” The double bottom pattern commonly marks the end of a downtrend. A downtrend is often defined as a series of lower highs and lower lows, warning investors of the changing trend that occurs when the security fails to make a new low. The pattern is complete when the security creates a new higher high. We will break this pattern down by each segment:
The prior trend is always down before a double bottom formation occurs.
The first low in the pattern doesn’t necessarily appear any different from previous lows in the downtrend.
After bouncing up off the previous low, the following peak will usually rally up near the previous high. This rally is commonly accompanied by stronger volume as bulls attempt to take control of the security.
After resistance is tested a sell-off will occur on light volume and the stock will move down near the previous low.
A support bounce near the previous low will be followed by another rally, making two fairly equal lows. The two similar lows create the double bottom or “W” appearance.
The pattern isn’t complete until the rally results in a higher high. Usually the stock will move above the previous high with greater-than-average volume.
To estimate a price target, subtract the price difference from resistance (top horizontal line) from lower support (bottom horizontal line) of the “W.” Add this amount to the resistance line price to establish a potential price target.
Cup and Handle Continuation
The cup and handle is a bullish continuation pattern that usually forms within a longer term uptrend. The pattern appears on the chart in the shape of a cup with a handle on the right side. After an advance, the stock meets a resistance level and goes into a consolidation period that takes the shape of a cup or saucer. Eventually, the stock works its way back to the initial resistance area and experiences a smaller, quicker decline, which forms the pattern’s handle. Finally, the stock breaks above resistance with increased volume, signaling the prior uptrend is resuming.
The following defines the structure of a cup and handle pattern:
Because the cup and handle is a bullish continuation pattern, an uptrend of at least several months should be in place prior to the pattern’s formation.
The cup should be "U" shaped and resemble a saucer, as opposed to being "V" shaped because V- shaped recoveries are less likely to be bullish continuation patterns. Both sides of the cup should be at relatively equal highs, although sometimes the cup will appear to be tipped on its side.
The cup’s depth can retrace anywhere from 1/3 to 2/3 of the prior uptrend. Typically a shallower cup depth is desirable, but more volatile market conditions can produce a deeper cup.
The handle is the final pullback before the breakout, much shorter and shallower than the cup. It forms on the right side of the cup and looks like a flag or pennant.
The cup typically forms over a period of two to eight months, and up to 16 months on a weekly chart. The handle usually completes in one to two weeks.
To be consistent with a bullish continuation pattern, volume should increase as price rises and decrease as price declines or consolidates. Volume should increase by at least 50% of average daily volume when the stock breaks above the top of the cup (resistance).
After a breakout, the target price is projected by measuring the distance between the bottom (support) and top (resistance) of the cup, then adding that distance to the top of the cup.
Flag and pennant patterns are considered to be some of the more reliable stock chart formations. Many chart technicians feel it is simple to identify entries and exits to maximize trading profits. Both patterns are common and reliable continuation patterns and they can appear in both up- and downtrends. They are identified by an initial strong trend, followed by a period of short-term consolidation or indecision and concluded by an additional strong move. After the short-term consolidation is broken, confirmed by strong volume, the trade is again in the direction of the original move. If there is not a strong initial move, it is most likely not a flag or pennant.
The following defines the structure of a flag/pennant pattern:
The initial trend is estimated by using higher highs and higher lows for an uptrend or lower highs and lower lows for a downtrend. But the flag pole is typically just a move from support to resistance. The uninterrupted initial move from the low to the high is referred to as the flag pole. This is the length, in dollars, of the initial move. It is also the determining factor in the target price. If there is not an easily definable flag pole, it is most likely not a flag or pennant.
Flag and pennant patterns are very similar to each other. Both patterns must have a strong trend to create the flag pole. The breakout entry point of both patterns is the same as well. The only difference in the patterns is that flags consolidate in a channel with parallel support and resistance, while pennants consolidate in a triangle pattern with declining resistance and rising support.
Although the entire pattern is referred to as a flag pattern, the flag portion of the pattern is only the consolidation portion. Similar to a flag, the pennant pattern is the pattern and the pennant by itself is only the consolidation portion.
The most common time frame for a flag or pennant is the intermediate term (weeks to months) but may also work well in the short term (days to weeks). It is very common for a flag or pennant to retrace ½ of the flag pole. If it retraces more than ½ of the original move, it is most likely not a flag or pennant.
The entry point for the trade is the breakout at end of the consolidation, flag or pennant, but only if it is in the direction of the original trend.
Volume should be high during the flag pole, then light and falling during the flag or pennant. It is common to see an increase at the entry point when resistance or support is broken.
The price target is simply estimated by adding the length of the flag pole to the breakout point of the flag pattern. Investors who trade these patterns will view the flags at “half-mast.” The theory behind the target is that flags and pennants occur at the halfway point of an overall move.
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