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Trader's Corner

Five Chart Patterns to Pay Attention To

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I received a SUBSCRIBER E-MAIL by way of a follow up question on my Trader's Corner musings of last week about the Head & Shoulder's (H&S) bottom price pattern that had been traced out in the S&P and Dow Indices. This article is found in your 9/13 saved Option Investor Daily e-mail (you do save them!?) or can be seen online by clicking here.

I've been talking about the 'minimum' upside objectives implied by the H&S bottom for some time in my weekend online Index Trader column and lo and behold the OEX hit that target (612) today. And, speaking of 'lo', Dr. Andrew Lo of MIT did some sampling and testing work to see what technical patterns, if any, had a significant predictive value. He and his colleagues found 5 actually worthy of following up on based on having statistical significance. And, that was the Subscriber question: what are the other 4 patterns that have shown to have a predictive outcome well above a chance or a random result?

The 5 chart patterns worth following once they form are:
1. The Head & Shoulder's (their conclusion was on the H&S TOP pattern, as the H&S bottom doesn't act quite as reliably, although its quite good)
2. The Double Top
3. The 'rectangle' top
4. The 'rectangle' bottom
5. The 'broadening' formation

THE HEAD & SHOULDER'S
The Head & Shoulder's (H&S) bottom is sometimes called the 'inverse H&S', as it's the reverse pattern to the three top pattern of the H&S Top. The H&S bottom pattern consists of a low (left shoulder), a lower and final low (the 'Head') and a secondary low that's in the area of the FIRST low. The measurement for a 'minimum' objective is the distance from the lowest low up to the 'neckline' added to the 'breakout' point. The distance traveled can be of course MORE THAN the minimum objective. The distance traveled after the breakout above the downward sloping neckline can be LESS than the measured objective also of course, but this is less common than the objective at least being achieved or exceeded.

The foregoing description is demonstrated by the markings on the S&P 100 (OEX) chart below:

Often in a prolonged and powerful advancing wave or movement like this, the market may be 'climbing a wall of worry'. Factors exist that keep investors and traders from getting bullish in the extreme and this is seen in my 'sentiment' indicator above; i.e., the lowermost chart of the CBOE Equities Call to Put ratio.

OTHER INDEXES AND OTHER PATTERNS:

The S&P 500 (SPX) chart next will show both the possible H&S bottom minimum upside target AND the possibility that this could be a DOUBLE TOP, which is #2 of the top-5 most reliable chart patterns suggested by Dr. Lo's study:

A 100% retracement of a prior price swing, that doesn't continue on in the same direction but instead reverses direction is a double top, or double bottom, chart pattern.

In the case of SPX below there exists the possibility that a double top could be setting up. Trader's are aware of this of course and may well sell into the prior top area. With a possible double top, it's necessary to not jump to conclusions too fast, as it can take a few days (or weeks, in the case of the weekly chart) before it becomes clear as to whether there will 1. just be a shallow pullback, then a push to a NEW high or 2. a sharp reversal and/or significant retracement of the prior/recent price swing.

Sometimes traders, myself included, especially when this pattern presents itself ALONG WITH an 'overbought' extreme such as seen below with the 13-day RSI, will make a trade based on an 'assumed top', which is to assume that a top has been made and take out puts with a 'tight' stop just over the most recent price peak. If the trade works out, if the stock or index HAS formed a double top (or double bottom) the risk (to just over the prior high) is quite SMALL relative to the 'reward' potential of even a nominal retracement of the prior advance; e.g., 33-40%.


GOLD BUGS BEWARE:

Regarding Head and Shoulder's top patterns, there is major one that has formed in the Philly Gold and Silver stock Index (XAU) on a weekly chart basis. You see this chart below, shown as a weekly line (close-only) chart. You'll note that the top forming the 'right shoulder' (RS) doesn't have the simple one peak look of the left shoulder (LS).

This is fairly common and simply makes this last and final top of the variety that's sometimes called 'complex' as in a complex right or left shoulder. The idea is the same however; i.e., the second peak (RS) is in the approximate same area as the first top (LS) and can't get to a higher high. After this kind of pattern, the next move is usually down, sometimes piercing the upward sloping 'neckline' of the H&S top pattern. A measuring rule of thumb is suggested here, which is for an eventual 'minimum' target on the downside, to around 100. Stay tuned on this outcome. Those gold bugs don't give up easily these days!


RECTANGLE TOPS AND BOTTOMS:

These two patterns are #3 & #4 of the top-5 predictive chart patterns according to this one (M.I.T.) study.

The next chart of the S&P 100 or OEX during late-2003/early-2004 outlines what is not the most classic rectangle bottom, which usually has 3 or more tops and 3 or more bottoms in the same approximate area. However, in the example below, the 3rd top and 3rd bottom were experiencing 'compression' as the price range narrowed in.

The time span is typical for a rectangle top or bottom: 6 months or more in the case of a daily/weekly chart time frame. There is a very low 'failure' rate to this pattern when prices break out to the upside. The average rise after prices pierce the upper line is around 46%, with the most likely rise to be 20%. The 'classic' price target, once the upper line of the rectangle is pierced is for a move EQUAL to the price distance between the upper and lower lines of the rectangle.

The 588 eventual upside objective, implied by the 'classic' measurement of a move equal to the height of the rectangle once prices broke ABOVE the top of the pattern, was of course eventually met but not until this year.

THE RECTANGLE TOP
This is the reverse of what you see above, with a final rally hitting a top, followed by a decline, then another top in the same area (a 'double top'), another bottom in the same area as the low end of the first pullback and so on. Eventually, there is a breakdown BELOW the lower end of the rectangle top, followed by a new down 'leg'.

I'll show this pattern in my next week's Trader's Corner along with the more elusive 'broadening' formation, #5 in the top-5 chart patterns destined for trading success. And on that note, wishing you GOOD TRADING SUCCESS in the meantime!

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