Popular Price Patterns and Their Meaning
The trading range of a stock provides order and the basis for testing potential later price movement. Following are some of the most popular and useful technical patterns and trends used by traders.
The head and shoulders is a very well-known and often-observed pattern.
Key PointThe head-and-shoulders pattern is a reliable one because it involves a three-part failed test of resistance. This is most likely to lead to a decline after the pattern develops.
For example, the chart for Boeing in Figure below shows a head-and-shoulders pattern testing the resistance level of about $73.50 (shoulders) and a very brief breakout (the head). After this, the price falls strongly.
[caption id="attachment_12752" align="aligncenter" width="550"] Head and shoulders.[/caption]
A head and shoulders is usually going to test resistance without breaking through. In this case, the assumed resistance was broken very briefly, and that failed breakout added to the downward momentum in the reaction trend that followed.
An opposite pattern is the reverse head and shoulders, which is identical except that the spikes approach or pass support in an attempt to drive prices downward, and the reaction is for prices to trend upward.
An example of the reverse head and shoulders occurred in the three-month chart of Yahoo! shown in Figure below. In this case, the pattern developed after a brief and weak uptrend. The reverse head and shoulders acted just as expected, with prices then breaking into an uptrend that moved strongly for more than two weeks.
[caption id="attachment_12753" align="aligncenter" width="550"] Reverse head and shoulders.[/caption]
These patterns do not have to be perfect or even especially strong for their meaning to provide good signals. With all indicators, the stronger the pattern, the better the information it provides. However, in these examples of the head-and-shoulders patternâwhich involves three separate price spikesâeven a relatively weak pattern is worth observing, especially if it is also confirmed by other indicators.
The Boeing chart ("Head and shoulders" shown in figure above) includes the very interesting downward-trending day with the long lower shadow as the third in four downward-moving days, then a gap, and then an upward movement. This volatility can be unsettling; however, as the final leg of the head-and-shoulders pattern emerged, the likelihood of a subsequent downtrend became clear. The long lower shadow and then the gap confirmed the volatility of what was emerging. But would that be upward or downward volatility? The head-and-shoulders pattern decided this convincingly.
Key PointAny technical pattern may vary in its strength or weakness. It is a mistake to wait for a âperfectâ or classic example, when a relatively weak pattern has the same significance in predicting price developments.
The reverse pattern for Yahoo! ("Reverse head and shoulders" shown in figure above) was even weaker, but the strong uptrend that followed conformed to expectations after the reverse pattern was completed. The uptrend was rapid and, as later events showed, could not be held. After it peaked, two events occurred. First was the very large gap between two downtrend days. Second was the volume spike that followed immediately. This revealed that the uptrend had lost momentum and had reversed. A similar event was found at the bottom of the downtrend: a large gap as the downtrend turned into yet another uptrend.
The whole pattern of short-term trends and confirmed reversals involves constant testing of resistance and support. Review charts over several months to spot how these borders hold their importance even long after interim trends have developed and ended.
Beyond the valuable head-and-shoulders pattern are additional patterns that test resistance and support. A variation of testing resistance is the double top. In this formation, prices test resistance twice and then retreat in the opposite direction. The double top is an especially strong bearish development because it demonstrates the significance of resistance when it holds; price not only backs away but tends to fall dramatically after the double top.
The double top may occur after an uptrend or at the conclusion of a sideways movement. For example, as shown in Figure below, Ford saw a double top after an uptrend, and in the middle, prices retreated before rising again. However, after the second attempt at further upward movement, prices retreated strongly.
[caption id="attachment_12754" align="aligncenter" width="550"] Double top.[/caption]
The opposite pattern is the double bottom, which involves two tests of support followed by a reversal and an uptrend. This occurs either after a downtrend or during a sideways movement when buyers and sellers are struggling for control.
Microsoft's chart showed an example of this, as seen in Figure below. After the double bottom, prices rose but could not be sustained. Price levels finally retreated once again to the level before the double bottom occurred.
Key PointDouble tops and bottoms are good ways to spot failed breakout attempts, and to anticipate price movement in the opposite direction.
[caption id="attachment_12755" align="aligncenter" width="550"] Double bottom.[/caption]
Technical analysis is all about patterns, as the head and shoulders and double tops/bottoms reveal. However, it is not only the price level that holds significance to traders, but changes in the breadth of the trading range itself. When the breadth narrows over a series of sessions, it provides a clue of a coming reversal. So the triangle is a pattern of declining breadth, and it should not be ignored.
When you see an ascending triangle, which occurs during an uptrend, it often means a reversal will occur when the breadth reaches a very narrow point. It consists of flat resistance and rising support.
DuPont's chart included an example of an ascending triangle lasting about one month, and this is shown in Figure below.
[caption id="attachment_12756" align="aligncenter" width="550"] Ascending triangle.[/caption]
This pattern ends with an exceptionally strong bearish engulfing pattern at the very top of the trend. The combination of the triangle and the engulfing pattern confirms the reversal, which occurred immediately after this development.
The opposite pattern, the descending triangle, involves a flat support and declining resistance. As the breadth shrinks, the expectation of reversal and uptrend is strong.
Key PointConfi rmation vastly improves a trader's accuracy in predictive analysis. For example, when a triangle occurs along with an engulfing pattern, those are two strong clues that prices are going to reverse.
An example was seen in the case of Verizon, as shown in Figure below. This gradually declining breadth was typical of a pattern taking place just before reversal and an uptrend.
[caption id="attachment_12757" align="aligncenter" width="550"] Descending triangle.[/caption]
By Michael C. Thomsett