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HEAD AND SHOULDER PATTERN

By Daryl Guppy

Some patterns are just imagination. They look impressive, and may even have exotic names, but they are not particularly reliable or useful for making trading decisions. We avoid these patterns. The head and shoulders pattern is a very reliable way to understand the developing behaviour of the market. The head and shoulders pattern consists of three distinct peaks. This pattern cannot be reliably identified until the right shoulder, or third peak, has formed or been confirmed. Unfortunately, by this time the market has already declined. However the pattern is very useful for setting targets for the coming market fall. Knowing these points helps traders to plan when to re-enter the market.
The left ‘shoulder’ is formed at the end of a long uptrend that usually has been in place for several months or longer. Prices fall far enough to signal an end to the previous uptrend. This leaves a peak, or shoulder. Prices then rally to form another peak that is higher then the left shoulder. Prices decline from this peak and create a new short term downtrend. This forms the ‘head’ of the pattern. Usually it takes several weeks between the peak of the left shoulder and the peak that forms the head.
The pattern cannot be fully recognised or confirmed until the right ‘shoulder’ is formed. Again this usually takes several weeks as prices must fall, rally to a new lower peak, and then fall again. Only after the right shoulder has been confirmed can traders really recognise a head and shoulders pattern. This is a pattern that develops over months, not days.
This pattern confirms a high probability that the previous long uptrend has ended, and, more importantly, it sets targets below the current price for the following downtrend. These targets are set by plotting a ‘neckline’ and then measuring the distance between the neckline and the top of the head.
 The neckline joins the base of the left shoulder with the base of the right shoulder. It may slope up, down, or horizontally. The slope does not have any particular significance. The neckline provides a measurement point.
The distance between the top of the head and the neckline is then projected downwards from the neckline to set a lower target. This is the level where we expect the market to pause and rebound. Often these targets look very low, but they are reached in many cases. It is this feature that makes the head and shoulders pattern so reliable.
The KLCI chart shows the recent head and shoulders pattern and the index targets at 860. Some traders used this pattern to establish buying orders at 860. They were able to enjoy a rapid rebound from this target area as the index moved upwards. Other traders prefer to wait for proof that these targets are valid. They were also able to join the new uptrend early in its development. This is the most useful application of the head and shoulders pattern. It confirms the end of an uptrend, and helps traders to decide the best time to re-enter the market as the new downtrend hits the lower targets set by measuring the head and shoulders pattern.
 

 


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