Technical Analysis Explained Page 11

  CHART 8.4 St. Jude Medical Featuring a Consolidation Rectangle

  Finally, Chart 8.5 features Moser Baer, an Indian stock, that shows the formation of a rectangle top. It meets the minimum requirement of trendline touches, so the lines as support or resistance areas are not that significant in themselves.

  CHART 8.5 Moser Baer 2006–2008 Rectangle Completion with Multiple Objectives

  During the formation of the rectangle, the odd day experienced an expansion in volume, but the overall trend is a declining one. The fact that prices fell so sharply after the breakout is testament to the fact that volume does not necessarily have to expand on the downside. Prices can just as easily fall due to a lack of bids. Note also that while the price almost reached three times its objective, the level of the actual objective (A) became a resistance area on the way back up. Consequently, it’s always a good idea to measure for these objectives at the outset because you can never be sure where prices might find timely reversal points.

  A lot of the time, we find price moves following breakouts from consolidation patterns to be quite substantial, often more so than from reversal patterns. That’s because reversal patterns need to build up some momentum, whereas momentum was already in place prior to the formation of the consolidation pattern.

  Major Technical Principle Volume usually leads price.

  Head and Shoulders

  Head and Shoulders as Reversal Patterns

  At Tops Head and shoulders (H&S) are probably the most reliable of all chart patterns. They occur at both market tops and market bottoms. Figure 8.21 shows a typical head-and-shoulders distribution pattern. (See also Chart 8.6.)

  FIGURE 8.21 Classic H&S Top

  CHART 8.6 The New York Times Average, 1928. This chart of the New York Times average of 50 railroad and industrial stocks shows the formation of an upward-sloping H&S during March, April, and May 1928. The minimum downside objective of about 182 was achieved fairly quickly, but a three-month period of base building commensurate with the H&S pattern was still necessary before the effect of the distribution was cancelled out and prices were able to resume their primary advance. Note the heavy volume on the left shoulder and head and the relatively low volume on the right shoulder. Also, activity declined substantially during the formation of the triangle, but began to expand during the breakout in September; a bullish expansion in such a volatile manner was a strong warning of the underlying weakness. A small right-angled broadening formation seemed to develop in July and August, but this would eventually prove to be the left shoulder of a 2½-month H&S pattern, the completion of which terminated the long bull market. Triangles and broadening formations are discussed later.

  It consists of a final rally (the head) separating two smaller, although not necessarily identical, rallies (the shoulders). If the two shoulders were trends of intermediate duration, the first shoulder would be the penultimate advance in the bull market, and the second the first bear market rally. The head would, of course, represent the final intermediate rally in the bull market.

  Volume characteristics are of critical importance in assessing the validity of these patterns. Activity is normally heaviest during the formation of the left shoulder and also tends to be quite heavy as prices approach the peak. The real tip-off that an H&S pattern is developing comes with the formation of the right shoulder, which is invariably accompanied by distinctly lower volume. Quite often, the level of volume contracts as the peak of the right shoulder is reached. The line joining the bottoms of the two shoulders is called the neckline.

  If you look carefully at Figure 8.21, you will appreciate that the violation of the neckline also represents a signal that the previous series of rising peaks and troughs has now given way to at least one declining peak and trough. The right shoulder represents the first lower peak and the bottom of the move following the breakdown, a lower trough.

  The measuring formula for this price formation is the distance between the head and the neckline projected downward from the neckline, as shown in Figure 8.21. It follows that the deeper the pattern, the greater its bearish significance once it has been completed. Sometimes, a head-and-shoulders completion will be followed by a fairly extensive downtrend; at other times, the negative effect of the pattern will be quickly cancelled by the completion of a base.

  Often, traders will observe the formation of a head-and-shoulders top and anticipate a breakdown. This is an incorrect tactic based on this evidence alone because it is not known until later whether the prevailing trend will continue or if a reversal signal will be given with a decisive break below the neckline. Over the years, I have seen many analysts who should know better forecast a bearish trend based on an incomplete head-and-shoulders top. Remember, in technical analysis, the prevailing trend is assumed to be in force until the weight of the evidence proves otherwise. An incomplete head and shoulders is not evidence, just a possible scenario. Moreover, since a right shoulder rally should be accompanied by a trend of shrinking volume, one that develops under the context of heavy volume provides a clue that the “top” will fail.

  H&S patterns can be formed in 10 to 15 minutes or can take decades to develop. Generally speaking, the longer the period, the greater the amount of distribution that has taken place, and, therefore, the longer the ensuing bear trend is likely to be. The larger H&S formations are often very complex and comprise several smaller ones, as shown in Figure 8.22.

  FIGURE 8.22 Complex H&S

  The H&S patterns illustrated in Figures 8.21 and 8.22 have a horizontal neckline, but there are many other varieties (as Figure 8.23 shows), all of which possess the same bearish implications as the horizontal variety once they have been completed.

  FIGURE 8.23 H&S Variations

  Chart 8.6 shows a classic H&S pattern that formed in the middle of 1928.

  At Bottoms Figure 8.24 shows an H&S pattern at a market bottom; this is usually called an inverse H&S, a reverse H&S, or an H&S bottom.

  FIGURE 8.24 Classic Reverse H&S

  Normally, volume is relatively high at the bottom of the left shoulder and during the formation of the head. The major factor to watch for is activity on the right shoulder, which should contract during the decline to the trough and expand substantially on the breakout (see Chart 8.7).

  CHART 8.7 DJIA 1898. This downward-sloping, inverse H&S pattern developed in the spring of 1898. Note that the April rally developed on very low volume. The subsequent reaction successfully tested the March low, and the ensuing breakout rally was accompanied by a bullish expansion of volume.

  That’s an ideal situation, but it is surprising how many successful breakouts develop under circumstances where the volume does not expand noticeably. If it contracts on the breakout rally, that is a definite no-no and is a strong sign that the breakout is likely to fail. Like the H&S distribution patterns, the inverse (accumulation) H&S can have a number of variations in trendline slope, number of shoulders, etc. Usually, the more complex the formation, the greater its significance. This goes back to the idea that price formations represent battles between buyers and sellers; the more battles that take place, i.e., the greater the complexity, the more significant the new trend once the battle has been resolved. Some of these reverse head-and-shoulders variations are shown in Figure 8.25.

  FIGURE 8.25 Reverse H&S Variations

  H&S patterns are extremely reliable formations, and their successful completion usually gives an excellent indication of a trend reversal.

  H&S Formations as Continuation Patterns

  H&S and reverse H&S formations occasionally show up on the charts as continuation patterns. Measuring implications and volume characteristics are the same as for the reversal type. The only difference is that these patterns develop during a trend rather than at the end. Chart 8.8, featuring AEP Industries, shows a great example of a continuation reverse head and shoulders, complete with a huge expansion of volume just before and just after the breakout. Substantial markup phases such as this are not uncommon following thes
e continuation formations.

  CHART 8.8 AEP Industries 2011–2012 Featuring a Reverse Head and Shoulders

  Head-and-Shoulders Failures

  We have already established that prices are determined by crowd psychology. Individuals can and do change their minds; so can crowds, and therefore, markets. As a result, what might appear to be a perfectly valid head-and-shoulders breakout one day may well turn out to be a whipsaw the next. This is generally not the case, but any trader or investor who does not recognize the ability of markets to reverse otherwise perfectly legitimate signals is in a state of delusion.

  The first step is to make sure that the pattern you are following is indeed a legitimate formation. For example, the price action may exhibit all the characteristics of an H&S distribution pattern, but the price refuses to penetrate the neckline. We have already established that until the formation is completed with a decisive break below the neckline, it is not a true pattern. This is because the neckline represents a support area, and support has not been violated. In the case of a horizontal formation, failure to penetrate the neckline also means that the series of rising peaks and troughs is still intact.

  Chart 8.9 features a reverse head and shoulders for Albertson’s that did not work. The price rallied up to the (solid) neckline for a final time in mid-2002, but was unable to push through.

  CHART 8.9 Albertsons 1998–2003 Featuring a Failed Inverse Head-and-Shoulders Pattern

  The dashed trendline is there to indicate that the final part of the head and the potential inverse right shoulder actually formed a head-and-shoulders top. Often, it is possible to spot these technical situations where the glass is half full or half empty. In this case, it was half empty, and the price declined.

  Failures used to be fairly rare, but they now appear to be more common, which indicates the necessity of waiting for a decisive breakout on the downside (or the upside in the case of a reverse head and shoulders). They typically develop when the pattern suggests a break in the opposite direction to the then-prevailing trend. Obviously, if this is the actual top or bottom, the formation will be valid. However, when a head-and-shoulders top forms in a bull market and does not experience a meaningful decline, this will tend to be a countercyclical signal. In fact, the very failure of the pattern may be interpreted as a sign that the prevailing (dominant) trend probably is still in force.

  There are several points in the chart where the probabilities of a valid signal sink below 50 percent and those of an outright failure start to increase. Figures 8.26 and 8.27 try to address these points. Point A in Figure 8.26 represents the bottom following the break below the neckline.

  FIGURE 8.26 Identifying an H&S Failure

  FIGURE 8.27 Identifying an Inverse Head-and-Shoulders Failure

  The next rally, which ends at B, is a perfectly typical development because retracements are a normal, and indeed healthy, phenomenon. The price then falls to C and something unexpected happens: Instead of following through on the downside, as would be expected from a head-and-shoulders top, the price rises back to the neckline again. This is the first sign that things may not work out as expected. When the price once again rallies back above the neckline (D), the odds of a failure increase. The balance tips more to the bullish side when the price moves above the down trendline joining the head with the right shoulder (E). This is probably the time to cover all shorts, since the reason for going short in the first place—i.e., the breakdown—no longer exists. The nature of the trendline will have a great deal to do with the change in probabilities. For example, if the line is steep and has been touched only twice, it will have nowhere near as much significance as it would if it were shallow and had been touched several times. A refresher on trendline interpretation in Chapter 6 would be a good idea at this point.

  The next line of defense is the right shoulder. If the price can rally above this point (F), then in some cases, it will now be experiencing a series of rising peaks and troughs. Finally, when the price moves above the head, the pattern is cancelled beyond a reasonable doubt.

  If action on the long side is contemplated, it should be taken either when the price breaks above the trendline joining the head and the right shoulder (line E) or when it breaks above the right shoulder (F) on heavy volume. Usually, such signals offer substantial profits in a very short period of time and are well worth acting on. Again, some common sense comes into play, for if the trendline joining the head and the right shoulder is unusually steep and has been touched only twice, it will not have the authority of a shallower trendline that has been touched or approached on numerous occasions.

  Inverse H&S patterns can also fail, as we see from Figure 8.27.

  Again, the failure is usually followed by a fairly lengthy decline as participants who bought in anticipation of an upward breakout are flushed out when the new bearish fundamentals become more widely known. Note that the line joining the head with the right shoulder is more significant in this example than that in Figure 8.26. That’s because the line is shallower and has been touched on more occasions. The joint break with the neckline is also impressive and would greatly increase the odds of a failed pattern. The move below F obviously puts the issue beyond any reasonable doubt.

  Chart 8.10 shows a failed head-and-shoulders top for Andrew Corp. This one developed during a very strong linear bull market.

  CHART 8.10 Andrew Corp. 1993–1994 Featuring a Failed Head-and-Shoulders Top

  The first indication of failure would have been given when the price broke back above the neckline after forming a small base. The clincher developed when the dashed trendline joining several rally peaks was bettered on the upside. Failed patterns are often followed by dynamic moves in the opposite direction to that indicated by the pattern. The rationale for this lies in the fact that market participants who bought or sold short, depending on the direction of the whipsaw, are caught on the wrong side of the market and are forced to liquidate. As a result, false moves should be viewed not with fear, but as an opportunity for profits. The degree of opportunity will depend on the strength of the signal and the closeness at which a realistic stop can be placed (the perceived risk). In this case, the trendline was a very strong one, and a stop could have been placed just below the low of the breakout day. Provided it was bought pretty close to the breakout point, this would have represented a very low-risk, potentially high-reward trade.

  Major Technical Principle If a technical signal is going to fail, it is often because it is taking place in the opposite direction to the main trend.

  Double Tops and Bottoms

  A double top consists of two peaks separated by a reaction or valley in prices. Its main characteristic is that the second top is formed with distinctly less volume than the first (see Figure 8.28 and Chart 8.11).

  FIGURE 8.28 Double Top

  CHART 8.11 DJIA 1936–1937 Double Top. Following a substantial advance from 1932, the first post-Depression bull market ended in 1937. The chart shows a classic double top. Note that the volume during the July-to-August rally was substantially below that of the January-to-March peak.

  It is normal for both peaks to form at the same price level, but it is also possible for the second peak to slightly exceed the first or to top out just a little below it. Remember, this is not an exact science, but a common sense interpretation of a battle between buyers and sellers.

  Minimum downside measuring implications for double tops, as shown in Figure 8.28, are similar to H&S patterns.

  A double bottom is shown in Figure 8.29. This type of pattern is typically accompanied by high volume on the first bottom, very light volume on the second, and very heavy volume on the breakout.

  FIGURE 8.29 Double Bottom

  Usually, the second bottom is formed above the first, but these formations are equally valid whether or not the second reaction reaches (or even slightly exceeds) the level of its predecessor.

  “Double” patterns may extend to form triple tops or bottoms, or sometimes even quadruple or ot
her complex formations. Some variations are shown in Figure 8.30.

  FIGURE 8.30 Triple Tops and Bottoms

  In some instances, it may be difficult to differentiate between a head and shoulders, rectangle, or triple top and bottom. That is not important. What is important is the fact that such formations represent a battle between buyers and sellers. When one side or the other wins out with a reversal in the peak/trough progression or the violation of a trendline, that’s what is significant. Remember, we give these patterns specific names for identification purposes. If a formation, say, breaks in a bearish way, it does not matter what you call it—it’s bearish and likely to lead to lower prices. That’s really the lesson to take home.

  Major Technical Principle Ultimately, it does not matter what you call a pattern—the important thing is whether it has bullish or bearish characteristics.

  The measuring implications of all these patterns are derived by calculating the distance between the peak (trough) and lower (upper) end of the pattern and projecting this distance from the neckline. Chart 8.12 Shows a classic double bottom in the DJIA in 1974 and 1962.

  CHART 8.12 DJIA 1962. This chart depicts a classic double bottom in the DJIA, which formed during 1962. Note that the second one was accompanied by lower volume than the first. While volume expanded during the breakout, the increase in activity was not particularly spectacular.