Formation of hourly chart 'Head & Shoulder's Top' patterns preceded the recent correction. Constructing uptrend price channels requires occasional re-drawn trendlines.

Head & Shoulder's (H&S) patterns, either Tops or Bottoms (sometimes called a 'reverse' H&S pattern) are highly predictive for downside or upside reversals respectively.

The H&S Top pattern consists of 3 highs with the first and last upswing peaks forming respectively, the 'Left Shoulder' (LS) and 'Right Shoulder' (RS). The middle high is the 'Head' and is normally, but not always, HIGHER than the left and right 'shoulder' highs. The chart below of this pattern is highlighted on the S&P 500 (SPX) hourly chart below. This Head & Shoulder's Top pattern is not as apparent or as fully formed so to speak on the SPX daily chart; you see the H&S Top pattern there also but without much 'detail'.

The substance of the H&S Top pattern is that there are 3 repeated highs. The fact that with SPX the Right (Shoulder) hourly top was a bit higher than the 'Head' doesn't negate the pattern. If the RS Top hit 1430 rather than 1420 that would make it a serious stretch as to SPX 'fitting' a Head & Shoulder's Top pattern.

Some traders sell into the third top and ASSUME that the pattern is a Head & Shoulder's (top) formation. The reliability of the pattern AS a top is that good; enough so that aggressive traders will sell before 'confirmation' of the (H&S) Top by the so-called neckline being pierced.

The math of this is straightforward and relatively simple. Straight down from the highest high of the Top to the neckline is the 'measuring' distance; 1418 - 1391 = 27 points. Deduct this from the 'breakdown' point or where the neckline was pierced; i.e., 1395 - 27 = 1368, which is a minimum (only) price objective. Of course sell offs after such a Top pattern forms can be deeper than this rule of thumb 'minimum' move objective as seen in our recent SPX example.

Head & Shoulder's patterns sometimes slope upward or downwards and that's the case with the H&S Top outlined on the hourly Nasdaq Composite (COMP) chart below which slopes UPWARD.

Another general rule of thumb is that the Left Shoulder (LS) and Right Shoulder (RS) tend to be about the same height but aren't always so equal. The COMP pattern below otherwise fits the basic pattern even though the Right Shoulder of the H&S Top is noticeably higher than the Left top. That creates the slope of the neckline and the entire H&S Top pattern.

With COMP the RS is LOWER than the Head which fits the general pattern, unlike how the RS was actually a bit higher than the middle top (Head) as seen with the Head & Shoulder's in the SPX chart above. You can see in these recent examples that the pattern can take some slightly different shapes but having the LS, Head, RS (3 tops) & neckline elements are basic.

In my 3/25/12 Trader's Corner (see the Trader's Corner tab on the OI Home page for the TC article archive) I described some of the basics of drawing trendline channels and how to place the all-important upper parallel line relative to a lower up trendline.

Recent weekly chart examples in Apple Computer (AAPL) and International Business Machines (IBM) demonstrate a key point in uptrend channel construction and the intersection points where resistance can be anticipated; or not, as you'll see.

There were 3 upper trend channel boundaries in AAPL, as part of three uptrend price channels that I was working with at different times in the evolution of AAPL's monster advance.

First was the lowermost uptrend channel. AAPL's up trendline was well-defined wand the initial requirement to construct an uptrend channel. The upper parallel line touches the highest prior high as seen below; until that is, there was the upside breakout above the upper channel line.

The second channel I worked with assumed that the lower prior high (lower chart left) would trace out a much broader AAPL uptrend channel.

However, since AAPL was in such a STRONG advance as prices went nearly vertical, I also worked with the possible outline of the third and broadest uptrend channel intersecting the highest prior price peaks. Sure enough, AAPL broke out above the second price channel I constructed but finally appears to have hit resistance at the broadest upper channel line intersecting near 650; the highest weekly high was 644.

There are few technical/chart methods to determine potential 'resistance' when a stock or index is at new all time highs, other than construction of an uptrend price channel. The upper channel line becomes a 'best guess' for potential resistance. Occasionally prices blow through the upper line. Often subsequent highs simply follow the upper trendline higher, rather than experience even a minor pause or downside reversal. If there's a breakout move I look for an alternative in my trend channel construction.

With IBM's weekly chart below, you will see the uptrend price channel I'm currently working with; resistance at the upper channel line comes in around 210 currently. If IBM achieves a decisive upside penetration of this trend channel, I'm going to assume that the broader trend channel might be the new 'roadmap' to IBM's trend and its implied upside resistance closer to 250 than 210.

You can sometimes rely on gauging the respective trend strength of a red-hot stock like Apple versus simply a very strong move in an IBM as to the likelihood of a breakout move above an uptrend channel or not. For example, I assumed AAPL would rally beyond any 'ordinary' move, whereas a mature company like IBM was much less likely to go into a straight up move.

In both stock charts seen above, I've also commented on where the Relative Strength Index or RSI indicator would 'confirm' a move to decisive new highs in the case of AAPL and where it would not as in the Price/RSI divergence in the case of IBM. This facet added to my view that IBM was not likely to break out above its broad uptrend channel. In any case, if you short the stock or buy puts the 'stop out'/exit point is a few points ABOVE the upper trend channel boundary in case there's a breakout move into a new broader/wider uptrend channel.


GOOD TRADING SUCCESS!