This chapter attempts to explain in both words and pictures the two chart pattern categories. Trend Reversal Patterns and Trend Continuation Patterns, and each of the specific patterns that fall into these categories.
Trend Reversal Patterns
Patterns that fall into the category of Trend Reversal Patterns include:
Head & Shoulder Tops, Head & Shoulder Bottoms, Triple Tops, Triple Bottoms, Double Tops, and Double Bottoms. As the name of this category implies, these patterns help the technician anticipate reversals in trend. For starters, we must first define a trend.
An uptrend is defined as a series of ascending peaks and troughs as illustrated below.
Conversely, a downtrend is defined as a series of descending peaks and troughs as illustrated below.
The default parameters in CPR require that the major reversal patterns, Head & Shoulders Tops/Bottoms and Triple Tops/Bottoms, be preceded by three or more successive peaks and three or more successive troughs. Double Tops/Bottoms require that the preceding trend have two successive peaks and troughs.
Changes in trend are not typically abrupt affairs. The battle between the forces of supply and demand take time to resolve. It is during these transition periods that clues in the form of Trend Reversal Patterns often appear.
Each of the Trend Reversal Patterns that CPR identifies have certain measuring techniques that help the analyst determine price moves and trade duration after the breakout.
Head & Shoulders Tops
The Head & Shoulders Top is undoubtedly the best known and perhaps the most reliable of all the major reversal patterns. This pattern, like others, is simply a refinement of the concepts of trend.
How the Head & Shoulders Pattern Forms
Picture an uptrending market with successive peaks and troughs each reaching higher than the previous. A sign that this upward momentum is slowing occurs when a trough forms about equal to the preceding trough (rather than above it). It is at this point that one should be alert. If the next rally fails to rise above the previous peak, then we have the makings of a classical Head & Shoulders pattern.
During the formation of this pattern, the forces of supply and demand are in relative balance. Once the distribution phase has completed, support along the bottom of the horizontal trading range (called the neckline) is broken and a new downtrend is established. The neckline is very often a slightly upward sloping to flat line. Less often it is downward sloping. This new downtrend will have descending peaks and troughs in the opposite direction of the trend that led up to the pattern.
The illustrations below show the formation of a typical Head & Shoulders pattern, beginning with an uptrend and the “left shoulder.”
After the formation of the left shoulder, prices rally higher and then retreat to form a “head.”.
Prices then attempt to rally once more, but fail to rise above the head thereby forming a “right shoulder.”
Often, after the breakout occurs, prices rally back up to the neckline (which now acts as upside resistance). From here, prices are expected to fall off and the new downtrend ensues.
Summary of Rules for a CPR Head & Shoulders Top Pattern
- A prior uptrend defined as three or more successive peaks/troughs.
- A left shoulder, followed by a corrective dip.
- A rally to new highs above the left shoulder.
- A decline that moves below the left shoulder and approaches the previous trough.
- A third rally that fails to reach the top of the head.
- A close below the neckline.
Trading the Head & Shoulders Top Pattern
The neckline of the Head & Shoulders pattern provides the trader with three critical pieces of information.
- It tells where to enter the trade (i.e., the breakout point).
- It is used in the calculation of the minimum price objective for closing the trade.
- It is the basis for the stop-loss level.
short signal at the open of the next day. The minimum downside price move is projected by measuring the height of the head to the next trough and projecting this distance downward from the breakout point. The maximum downside price move is the low of the bar at the start of the prior uptrend.
If the minimum price objective is not met within a specific time period or if prices rally above the neckline then the pattern is cancelled. The minimum time period for the pattern to breakout is equal to the distance from the head to the right shoulder projected from the right shoulder. The maximum time period for prices to reach the minimum price objective is equal to the distance from the left shoulder to the right shoulder projected from the breakout.
The min/max price objectives and stops are provided in the Expert Commentary (see page 27). Expert Alerts will also pop up and alert you on the breakout and exit days.