Tips on Technicals - Theme and Variation
Technical Analysis has always been considered an interpretive skill and often times cannot be tamed by mechanical systems. Even the latest "innovations" in setting trend lines and price targets still cannot substitute for the human mind in leaving room for variations of traditional patterns. In this chapter, we will examine one familiar price pattern in several different ways.
Head and Shoulders Standard
Most technical patterns can be applied to up and down markets with equal reliability so we will use a rising market here as our example. December 1995 CBT Wheat (figure 1) was making a series of higher highs and higher lows -- a classic indication of a bull market. In August, the market made a low at about the same level as the previous low and also failed to rally back to a new high. This failure to make a higher high is the first indication that a head and shoulders reversal pattern is in progress1. The highest high is called the "head" and the two peaks on either side are called the "shoulders." A line connecting the corresponding lows is called the "neck line" and provides support for the pattern.
In a simple head and shoulders pattern, the market should trade down from the top of the right shoulder towards the neck line. If the neck line is penetrated, the reversal pattern is completed and the market should move lower. If the neck line support level holds, then the market should continue higher as the reversal pattern failed to complete. The Wheat market bounced off the neck line area several times before it resumed its rally forming a complex version of a right shoulder. The rising trend line provided further support.
The failed head and shoulders pattern in this case allowed the market to work out the overbought condition caused by the accelerated June-July rally. Wheat then resumed a slower, but more sustainable, longer-term rally2.
Multiple Body Parts
While Wheat displayed a complex shoulder, it is not uncommon for a market to display a multiple shoulder, or even a multiple head. The Dollar/Mark rate (figure 2) was making higher highs and higher lows during its 1991 rally until a head and shoulders pattern completed in September of that year. The market made a lower low and lower high after the neck line broke which confirmed that a small bear market was in progress. However, the two peaks on either side of the head formed a pattern that also looked like a larger head and shoulders pattern surrounding the original pattern.
We can choose a new name for this pattern such as a "mountain top" pattern to differentiate it from a simple head-and-shoulders. The neck line in this case can be called the "tree line," which completes this analogy.
Since Dollar/Mark was already trading lower, this mountain top pattern did not serve to confirm or deny the current trend. However, when measured like a standard head and shoulders (top of head to the neck line), it projected the first target for the decline3. The tree line also served to resist the early 1992 counter trend rally.
Subjective and Interpretive
Analyzing multiple heads or shoulders, and even the different numbers of bars needed to complete these patterns, depends on the skills and experience of the analyst. While mechanized pattern recognition programs are useful, their learning abilities (artificial intelligence) cannot yet interpret the subtle and not so subtle violations and exceptions common in the real world. In the next chapter, we'll look at when to ignore pattern violations and how much error can be tolerated without degrading the analysis.
TEXT
1 See chapter "Bar Chart Patterns"
2 Note that the June-July rally ended with a smaller, yet successful, head and shoulder reversal.
3 See chapter "Measuring the Move"
