5.2 Technical Analysis – Reversal Patterns: Head & Shoulders, Double Tops and Bottoms. The head and shoulders pattern is the most reliable reversal pattern and works 85% of the time. Being a reversal pattern, it indicates a turnaround in the major trend. It can occur at the top or bottom of a price chart. To form head and shoulders pattern there must be at least five reversals of the major trend. In an up trend, the first correction (from reversal point 1) and the rally to a new high (from point two) are still compatible compatible with a bull market. market. The first two reversals will be known as the left shoulder. The reversal from point 3 will be known known as the head. If the third reversal takes prices lower than the top of the left shoulder, support support has been violated. This is the first sign of weakness in the major trend. The rally from reversal point four should occur on lower volume than the volume on any part of the previous rallies. The rally should not go to a new high, but reversal point 5 must be lower than reversal reversal point 3 (the top of the head). The neckline is the minor trend line drawn tangent to reversal points two and four. The trader should wait for a completion of the pattern by a close below the theoretical neckline. Then sell the share short or buy the share if an inverse Head and Shoulder pattern occur. The minimum objective can be determined by taking the distance from the top of the head (reversal point 3) to the neckline and adding that distance to the point where the neckline was broken. The trader should should take profits on at least half of his position. The trader can also establish a fail-safe line where he should should put a stop-loss. This line is the minor trend line drawn tangent to the top of the head and the top of the right shoulder (reversal points 3 and 5). Whenever prices move move above the fail-safe line, the trader should cut all his positions. Let’s look at at an example: example:
3 5
Head
Fail-safe Line
Right shoulder
1
Left Shoulder
Neckline
4 2
Min. Objective
Double Tops and Bottoms: “Two tops that approximately the same same price level” is only half the explanation. explanation. Prices must decline below and close below the low point established between the two tops (the middle reversal point) before a double top has been been activated. In a double bottom, prices must must close above the high point in between between the two bottoms to establish a double double bottom. Taking the distance from the double top or bottom to the point in between and adding that distance to the breakout level can determine determine the measuring objective. The middle reversal point will also provide support for any pullback.
