Cooking Tools #1: Chart Pattern Reversals

Continuing with yesterday's introduction to chart patterns, today we'll be looking at chart pattern reversals. These are useful tools in determining when a stock may be setting up for a reversal in price trend. Included in this discussion are double tops and bottoms and head-and-shoulders (not to be confused with the dandruff shampoo). Other reversal patterns include broadening formations and triangles, but they're not as easy to spot nor are they as reliable.

Since there are many books and websites that discuss these patterns in depth, I'm only going to touch on the salient points so that you will be able to identify them and know what to do when you see one.

DOUBLE TOPS & BOTTOMS:
A double top or bottom looks exactly what it sounds like. A double top looks like a rounded M and a double bottom looks like a rounded W. For simplicity, I'll discuss the characteristics of a double top; the commentary for a double bottom will be the reverse.

Characteristics: A double top occurs after a significant run-up in the stock, usually on the order of months or even years. The pattern is composed of two peaks of roughly equal height (they should be within 3-4% of each other) with a trough of about 10-20% off the peak high in the middle. The distance between the two peaks can be from several weeks to several months; too close and this could just represent normal resistance rather than a lasting change in the overall supply and demand. Once you learn how to spot a double top you'll know the difference between a minor fluctuation and a major reversal pattern.

How to play it: After the second peak has formed, the stock will decline on increased volume and/or experience downward gaps. What you want to do is wait and see if it will break the support line which is the horizontal line that goes through the peaks and touches the base of the trough. If it does break this line, it must do so on increased volume. A general rule of thumb is to wait a few days after the break before entering a short position (or selling the stock if you were long) to see if the break is real. Once the support line is broken it becomes resistance, and any retracement back to this line can be viewed as another chance to exit your long position and/or initiate a short one.

Price target: Subtract the peak value to the support line from the support line for a price target: Price Target = Support Value - (Peak value - Support Value). It follows then that the bigger the double top formation, the lower it can be expected to go. If you had shorted just below the support line break, you can expect to cover when it reaches its price target.

HEAD & SHOULDERS:
A head and shoulders pattern is one of the most powerful and reliable chart reversal tools. It's very smiliar to a double top except that it has an additional higher peak called the “head” located between the two lower peaks called the “shoulders.” The “neckline” is the support line drawn at the base of the troughs joining the head and shoulders. This line doesn't have to be horizontal; a sloping line is okay. Volume is crucial here. The volume of each successive peak must be less than the volume of the previous one. Overall, the volume should experience a significant decline during the course of pattern formation. If you have both the shape and the volume criteria, then you have correctly identified this powerful reversal pattern. Head-and-shoulder patterns typically take a couple of months to set up, although some can take longer.

How to play it: You play this exactly the same way as a double top.

Price Target: The price target is the same as in a double top except that you'll be using the top of the head as your point of subtraction: Price Target = Neckline (support) value - (Top of Head value - Neckline value). Note that other considerations can come into play when establishing a price target such as major support and resistance levels, Fibonacci levels (don't worry too much about that right now), and major moving averages.

Note: Since this pattern is so reliable, it is also very profitable and much coveted by traders. It is also a rare one, but I'll see if I can dig up a few stocks that are exhibiting this pattern so that we can follow their price action.