Matthew Kerkhoff, options expert and editor of Dow Theory Letters, continues his 14-part educational...
Famous Technical Patterns Every Trader Should Know
11/19/2015 7:00 am EST
Trend followers, momentum traders, and technical analysts are often looking for "tops" and "bottoms" in order to find trend changes. To basically define a top and a bottom, a top can be seen as the highest point in a stock's uptrend, usually followed by a decline of some sort (that would also be often called a "significant top"). The opposite is true for a bottom, which is the lowest point in a downtrend. You can have double tops/bottoms or triple tops/bottoms when a stock reverses its trend. In the case of a double top, the stock will pull back to support and make another run higher before reversing its trend (a bottom sees the stock test resistance). A triple top contains three runs higher and two pullbacks to support. Many technicians believe that the more tests of a support/resistance level, the more likely it is to be broken.
Technical analysts will look for specific patterns to indicate the strength or weakness of a stock, and some of them occur time and time again and are analyzed by many to be significant. One of those "famous" patterns is known as the head-and-shoulders pattern, so named because of its inclusion of two shoulders and a neckline.
The chart below demonstrates a sample head-and-shoulders formation:
Common Head-and-Shoulders Technical Pattern
The formation is comprised of a neckline, two shoulders (left and right), and a head-giving us the pattern's name. The neckline is created by connecting the low points of each of the shoulders, and this level acts as support (or resistance). The head is the highest point, while each of the shoulders is lower than the head (and often in a line with each other).
Notice that this particular head-and-shoulders pattern takes place in the midst of an uptrend, but the opposite can also occur. In a downtrend, the neckline acts as resistance and the head is the lowest point on the chart. This is sometimes called a "reverse," or "upside-down" head-and-shoulders.
Sometimes these formations are labeled head-and-shoulders tops, bottoms, or reversals. This occurs if the trend reverses direction after the formation completes. The prior chart is a good example of a head-and-shoulders top. The logic behind the breakdown of this pattern in the above chart is that the stock made a significant top, retraced to a previous lower top, then re-tested a support/resistance level (neckline)-this is a likely spot for a downside break in the pattern.
Another famous technical pattern is the "cup-and-handle" formation. As you can see on the chart below, this formation consists of a downtrend followed by a sideways trend then an uptrend. This section forms the cup, which is then followed by a bit of a consolidation downtrend, setting the handle. This is usually perceived to be a pattern that sets up an upside breakout, but as you can see by the following chart, it can also set up a big momentum down move. The logic behind this is basically that the stock has formed a bullish base, and the handle is the consolidation prior to the breakout.
Common Cup-and-Handle Technical Pattern
By Price Headley, founder and chief analyst, BigTrends.com
Related Articles on STRATEGIES
Profit from a market by capturing a trend. Money management is key. The battle is often from within,...
Has Mr. Market (S&P 500/Equities) priced into too much positivity, while inflation remains at ba...
Berkshire Hathaway (BRK.B) is well known as the huge operating and investment company that was built...