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Head And Shoulder Patterns: Just Mumbo-Jumbo?

  • Written by Syndicated Publisher No Comments Comments
    October 28, 2012

    First understand that our buy and sell signals are not based on patterns but on technical indicators that measure potential support/resistance levels, overbought/oversold conditions, internal strength, money-flow reversals, market momentum reversals, etc., with additional input from short-term and annual seasonality, investor sentiment, insider activity, valuations, etc.

    But like all technicians, we can’t help but notice when charts develop patterns that often areindicative of support/resistance levels having been reached, and tops or bottoms developing.

    They include double-tops, where the market has pulled back from a high, rallied back up and the rally attempt fails at the previous level, indicating that more participants are seeing risk and adopting a willingness to sell and take profits at that level. Double-bottom patterns often indicate the opposite, that selling pressure is letting up and a low has been seen, with buying repeatedly coming in at the level of the double-bottom.

    Other simple patterns include symmetrical triangles, flags, descending triangles, head and shoulder tops, reverse head and shoulder bottoms, and a few others.

    What they all have in common is that historically they were patterns present in a high percentage of times when market moves became more serious.

    What they also have in common is that they are not at all infallible, and so are easy prey to those critical of technical analysis of markets. That is, even though they do not provide buy or sell signals and are merely noted as patterns that may have potential significance if actual technical indicators have triggered signals.

    So at the present time the large number of potential head and shoulders tops showing up in markets, as well as in the charts of individual stocks, is interesting.

    A head and shoulders top pattern forms after an uptrend, and its completion often marks a trend reversal of either short-term or intermediate-term importance, depending on whether the chart is based on daily closes or weekly closes.

    The pattern consists of three successive peaks, with the middle peak being the highest (the head), and the two outside peaks being lower (the shoulders).

    The important part of the pattern is the ‘neckline’, a line drawn through the lows after the two shoulders are formed. It is only when a subsequent pullback from the right shoulder penetrates the neckline that the pattern completes and indicates a more dramatic decline ahead.

    This chart of France’s market illustrates both a completed head and shoulders pattern, and the current potential that one is forming. Note that this is on a short-term chart, and do not be misled. The current potential pattern has not completed and would disappear if the French market’s rally resumes to any degree.

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    A sampling of some of the other similar situations.

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    And here is an example of a potential intermediate-term head and shoulders top that was threatening but did not complete because the neckline was not penetrated on the subsequent decline from the right shoulder.

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    Fibonacci Patterns.

    Sometime around the 12th century Leonardo Fibonacci discovered a fascinating relationship between numbers in nature. His studies and findings, which began with his discovery of the mathematical pattern used in the construction of the Great Pyramid in Egypt, are now known as the Fibonacci sequence.

    Fibonacci Numbers are an unchanging sequence of numbers, beginning with 1, in which each number in the sequence is the sum of the previous two numbers. So the Fibonacci Numbers are 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, etc.

    There are several fascinating mathematical relationships between the numbers. For instance the ratio of any number in the sequence to the next highest number in the sequence is 61.8, while the ratio of any number to the next lowest in the sequence is 161.8

    There are also many fascinating relationships between Fibonacci Numbers and nature. Just a few examples out of hundreds;

    As shown in the picture below, there are 89 curves in the seed centers of sunflowers and daisies, of which 55 wind in one direction, while 34 wind in the opposite direction.


    Trees always branch from their base in Fibonacci series.

    In sound waves, a musical octave is comprised of 13 notes, of which 8 are normal (the white keys on a piano) while 5 are flats or sharps (the black keys on a piano).

    Fibonacci ratios are also found to be precisely followed in the spirals of various kinds of seashells.

    The Fibonacci relationships in nature are seemingly endless, and thought-provoking to say the least.

    In 1939, R.N. Elliott, a famous old-time market technician, began testing and applying Fibonacci patterns to the stock market.

    And for instance, as long-time subscribers might remember, it was the Fibonacci Retracement Levels applied to the Nasdaq in the year 2000 that provided considerable support for what our other indicators were telling us.

    After we aggressively sold the Nasdaq short as it approached 5,000, (based on our technical indicators including overbought/oversold indicators, and momentum reversal indicators), we were then able to use the Fibonacci Retracement pattern to predict a downside target of 3500 (which seemed impossible to most at the time in that ‘this time is different’ market bubble, but which was actually exceeded). We were then able to give 4,250 as the overhead resistance for the subsequent two rallies. And when the second rally failed at 4250, leaving a double top in place, we were confident enough to sell the Nasdaq short again, with a downside target back to test the previous low at 3200 (which was also exceeded in that awful bear market).

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    So while not providing buy or sell signals, patterns are often useful when other technical indicators do trigger buy or sell signals.

    To read my weekend newspaper column click here: Is The Market Plunging Over An Earnings Cliff-

    Subscribers to Street Smart Report: There is an in-depth ‘Gold, Bonds, Dollar, Commodities’update from Thursday and an in-depth ‘U.S. Market Signals and Recommendations’ update from Wednesday in your secure area of the Street Smart Report website. The next issue of the newsletter will be out next Wednesday.

     

    Images: Flickr (licence attribution)

    About The Author

    Sy Harding publishes the financial website www.StreetSmartReport.com and a free daily Internet blog at www.SyHardingblog.com. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beat the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!
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