Originally published by guppytraders.com
One of the most powerful and reliable diagram patterns is the head and shoulder pattern. This indicates a trend reversal. The pattern usually lasts several weeks or, with an index market, several months to develop and can best be seen on a weekly chart. Once confirmed, the pattern is used to set down targets that have a high degree of reliability. These goals are achieved in about 80% of cases and are often exceeded and that is 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 under an existing long-term trend line.
This is the end of a strong upward trend of the long term, so buyers return to the market and buy temporary downturns. Their purchases create a new rally and also confirm the development of the left shoulder of the pattern.
This is the activity in 2018 that is shown in January as point 1 on the map.
The reaction of the rally is often quite strong and is higher than the top of the previous upward trend.
The main difference in this uptrend continuation is when the second rally reaches a new peak and then collapses. This index withdrawal is significant enough to put an end to the recent rally. The index moves under the recent rally trend line and continues to decline.
Investors who have not bought the first dip, return to the market and expect a new rebound rally. This activity establishes the head in the head and shoulder pattern shown as point 3 on the map.
The two low points form the basis of the neckline of the pattern. The pattern, however, lacks the right shoulder. This has been made with the new rally rebound.
Two functions are required to confirm this as head and shoulder pattern. The first characteristic is that the top of the second rally is lower than the top that forms the head. This is shown as area 3? and will be determined by the rally caused by the 90 day delay in the trade war.
The second characteristic is that the head and shoulder pattern is only confirmed when the index falls below the projected value of the neckline. The value of the neckline is projected on the Dow card. A fall below this neckline on a market withdrawal confirms the head and shoulder pattern.
The two low points in the pattern – the beginning of the first and second rallies – are merged with a single trend line.
A line is pulled down from the top of the head to cross the neckline. This value, in index points, is then projected under the neckline. This is the first drawback for the downward trend of the market.
On the Dow chart, this represents a downward target in the neighborhood of 21250.
Patterns are rarely perfect, so investors see as much compatibility as possible and adjust the chance to reach 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 that investors are alert to a repeat of this pattern in 2018/19. The appearance of two right shoulders did not reduce the reliability of the pattern. The head and shoulder pattern will be invalid if the second rally is higher than the top of the previous rally – higher than point 2 of the card.
Daryl Guppy is a leading expert in the field of international financial technical analysis and special consultant for Axicorp. Guppy regularly appears on CNBC Asia and is known as "The Chart Man". Disclaimer: Daryl Guppy is not a financial advisor. These comments are for educational purposes only and provide an example of applied technical analysis.
