Traders love chart patterns because they point the way to high probability situations. These are situations where one type of outcome is much more probable that other outcomes. Knowing the market has a high probability of rise, or falling, or changing direction of the current trend provides an opportunity to make money or protect profits.
Many chart patterns lend themselves to measured move calculations. The depth or structure of the pattern provides a foundation for measuring the height of the potential rally, or the depth of the potential fall.
This is an invaluable aide for calculating risk and reward ratios, which are fundamental to trading and investment survival.
Some patterns are tactical. These point the way to short term behaviors developing over a short-term time frame. Flag patterns, triangles, cup and handle patterns all fall into this category.
Pattern development and the achievement of objectives can take 2 to 6 weeks and make them ideally suited to short-term trading. They are most useful when identified and applied to individual stocks.
Other patterns are strategic and point the way to long-term changes in market behavior. These are portfolio signals because they suggest its time to protect a broad range of portfolio positions, taking profits or tightening stops across all types of open positions. These types of patterns include the head and shoulder patterns, rounding tops, parabolic trends and double or triple tops.
They are most usefully applied to indexes and broad commodities. The intention is to identify a broad signal of change and then look more closely at individual positions in the portfolio. They act as an alert signal.
One of the most useful of these is the head and shoulder pattern. Its created by a sequence of three rallies and retreats. The head of the pattern is created by the middle rally. The base, or neckline of the pattern is created by the two intervening rallies.
These are joined with a trend line. The distance between the peak of the rally that forms the head and the trend line, or neckline is measured. The slope of this trend line has little impact on the reliability of the pattern. Up, down, or sideways, the trend line measurement still gives a reliable downside target.
The depth of the head and shoulder pattern is projected downwards and gives a minimum downside target. This powerful pattern developed in the Dow in 2007 and completed in early 2008. Investors who recognized the pattern protected their positions and were ready to go short in early 2008.
The inverted version on this pattern developed in the Dow recovery in 2009. This is a long-term pattern and it wasn’t until late 2010 that the pattern target objectives were achieved.
A new head and shoulder pattern has developed in the Dow. The rapid falls of last week confirmed the right shoulder of the pattern. The depth of the pattern puts the downside target near 11,600. This target level also matches the previous historical support and resistance level near 11,600.
The head and shoulder pattern provides a reliable method to calculate downside targets. It is often the beginning of a significant change in the trend so traders watch carefully for index behavior when the initial price targets are achieved.
The current head and shoulder pattern is small and unlike 2007/2008, the target projection is not catastrophic. This suggests a strong retreat in the Dow, but it is too early to know if this has a high potential to develop into a major retreat.
The current head and shoulder pattern is invalidate if the index is able to stage a rally and move above 12,600. This invalidates the head and shoulder pattern.
Analysts can come up with a variety of fundamental and behavioral reasons for the development of this chart pattern. They are of less interest than the immediate message delivered by the development of the pattern. This pattern signals a situation of potential trend change. Investors will protect open position, think more seriously about trading short and open new long side position with more caution.
Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –www.guppytraders.com. He is a regular guest on CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.
If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com.
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