often referred to as “selling
more important it becomes. climaxes.”Basic Concepts of Trend 93
 
 
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Figure 4.22c = The chart action of October 28, 1997 was a classic exam-ple of an upside reversal day or a “selling climax.” Prices opened sharplylower and closed sharply higher. The unusually heavy volume bar for that
 
 
 
 
 
 
day added to its importance. Two less dramatic upside reversal days (seearrows) also marked price bottoms.
Weekly and Monthly Reversals
This type of reversal pattern shows up on weekly and monthlybar charts, and with much greater significance. On a weeklychart, each bar represents the entire week's range with the closeregistered on Friday. An upside weekly reversal, therefore, wouldoccur when the market trades lower during the week, makes anew low for the move, but on Friday closes above the previousFriday’s close.
Weekly reversals are much more significant than dailyreversals for obvious reasons and are watched closely by chartistsas signaling important turning points. By the same token, month-ly reversals are even more important.94 Chapter 4
 
PRICE GAPS
Price gaps are simply areas on the bar chart where no trading hastaken place. In an uptrend, for example, prices open above thehighest price of the previous day, leaving a gap or open space onthe chart that is not filled during the day. In a downtrend, theday’s highest price is below the previous day’s low. Upside gaps aresigns of market strength, while downside gaps are usually signs ofweakness. Gaps can appear on long term weekly and monthlycharts and, when they do, are usually very significant. But theyare more commonly seen on daily bar charts.
Several myths exist concerning the interpretation of gaps.One of the maxims often heard is that “gaps are always filled.”This is simply not true. Some should be filled and others should-n’t. We'll also see that gaps have different forecasting implicationsdepending on which types they are and where they occur.
Three Types of Gaps
There are three general types of gaps—the breakaway, runaway (ormeasuring), and exhaustion gaps.
The Breakaway Gap. The breakaway gap usually occurs at thecompletion of an important price pattern, and usually signals thebeginning of a significant market move. After a market has com-pleted a major basing pattern, the breaking of resistance oftenoccurs on a breakaway gap. Major breakouts from topping or bas-ing areas are breeding grounds for this type of gap. The breakingof a major trendline, signaling a reversal of trend, might also seea breakaway gap.
Breakaway gaps usually occur on heavy volume. More oftenthan not, breakaway gaps are not filled. Prices may return to theupper end of the gap (in the case of a bullish breakout), and mayeven close a portion of the gap, but some portion of the gap is oftenleft unfilled. As a rule, the heavier the volume after such a gapappears, the less likely it is to be filled. Upside gaps usually act as sup-port areas on subsequent market corrections. It’s important thatprices not fall below gaps during an uptrend. In all cases a closebelow an upward gap is a sign of weakness. (See Figures 4.23a and b.)Basic Concepts of Trend 95
 
Figure 4.23a The three types of gaps. The breakaway gap signaled thecompletion of the basing pattern. The runaway gap occurred at about themidway point (which is why it is also called the measuring gap). An exhaus-tion gap to the upside, followed within a week by a breakaway gap to thedownside, left an island reversal top. Notice that the breakaway and run-away gaps were not filled on the way up, which is often the case.
The Runaway or Measuring Gap. After the move has been under-way for awhile, somewhere around the middle of the move, priceswill leap forward to form a second type of gap (or a series of gaps)called the runaway gap. This type of gap reveals a situation wherethe market is moving effortlessly on moderate volume. In anuptrend, it’s a sign of market strength; in a downtrend, a sign ofweakness. Here again, runaway gaps act as support under the mar-ket on subsequent corrections and are often not filled. As in thecase of the breakaway, a close below the runaway gap is a negativesign in an uptrend.96 Chapter 4
 
 
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Figure 4.23b = The first box shows an “exhaustion” gap near the end ofthe rally. Prices falling below that gap signaled a top. The second box is a“measuring” gap about halfway through the downtrend. The third box isanother “exhaustion” gap at the bottom. The move back above that gap sig-naled higher prices.
This variety of gap is also called a measuring gap because itusually occurs at about the halfway point in a trend. By measur-ing the distance the trend has already traveled, from the originaltrend signal or breakout, an estimate of the probable extent of theremaining move can be determined by doubling the amountalready achieved.
The Exhaustion Gap. The final type of gap appears near the endof a market move. After all objectives have been achieved and theother two types of gaps (breakaway and runaway) have been iden-tified, the analyst should begin to expect the exhaustion gap. Nearthe end of an uptrend, prices leap forward in a last gasp, so tospeak. However, that upward leap quickly fades and prices turnlower within a couple of days or within a week. When prices closeBasic Concepts of Trend 97
under that last gap, it is usually a dead giveaway that the exhaus-tion gap has made its appearance. This is a classic example wherefalling below a gap in an uptrend has very bearish implications.
The Island Reversal
This takes us to the island reversal pattern. Sometimes after theupward exhaustion gap has formed, prices will trade in a narrowrange for a couple of days or a couple of weeks before gapping tothe downside. Such a situation leaves the few days of price actionlooking like an “island” surrounded by space or water. The exhaus-tion gap to the upside followed by a breakaway gap to the down-side completes the island reversal pattern and usually indicates atrend reversal of some magnitude. Of course, the major signifi-cance of the reversal depends on where prices are in the generaltrend structure. (See Figure 4.23c.)
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Figure 4.23c The two gaps on this daily chart form an “island reversal” top.The first box shows an up gap after a rally. The second box shows a down gapthree weeks later. That combination of gaps usually signals an important top.98 Chapter 4
 
CONCLUSION
This chapter introduced introductory technical tools that I con-sider to be the building blocks of chart analysis—support andTesistance, trendlines and channels, percentage retracements,speed resistance lines, reversal days, and gaps. Every technicalapproach covered in later chapters uses these concepts and toolsin one form or another. Armed with a better understanding ofthese concepts, we’re now ready to begin a study of price patterns.Major Reversal Patterns
INTRODUCTION
So far we’ve touched on Dow Theory, which is the basis of mosttrend following work being used today. We’ve examined the basicconcepts of trend, such as support, resistance, and trendlines. Andwe've introduced volume and open interest. We’re now ready totake the next step, which is a study of chart patterns. You'll quick-ly see that these patterns build on the previous concepts.
In Chapter 4, the definition of a trend was given as a seriesof ascending or descending peaks and troughs. As long as theywere ascending, the trend was up; if they were descending, thetrend was down. It was stressed, however, that markets also movesideways for a certain portion of the time. It is these periods ofsideways market movement that will concern us most in thesenext two chapters.
It would be a mistake to assume that most changes intrend are very abrupt affairs. The fact is that important changes intrend usually require a period of transition. The problem is that
99100 Chapter 5
these periods of transition do not always signal a trend reversal.Sometimes these sideways periods just indicate a pause or consol-idation in the existing trend after which the original trend isresumed.
PRICE PATTERNS
The study of these transition periods and their forecasting impli-cations leads us to the question of price patterns. First of all, whatare price patterns? Price patterns are pictures or formations, whichappear on price charts of stocks or commodities, that can be clas-sified into different categories, and that have predictive value.
TWO TYPES OF PATTERNS:REVERSAL AND CONTINUATION
There are two major categories of price patterns—reversal andcontinuation. As these names imply, reversal patterns indicatethat an important reversal in trend is taking place. The continua-tion patterns, on the other hand, suggest that the market is onlypausing for awhile, possibly to correct a near term overbought oroversold condition, after which the existing trend will beresumed. The trick is to distinguish between the two types of pat-terns as early as possible during the formation of the pattern.
In this chapter, we’ll be examining the five most com-monly used major reversal patterns: the head and shoulders, tripletops and bottoms, double tops and bottoms, spike (or V) tops andbottoms, and the rounding (or saucer) pattern. We will examinethe price formation itself, how it is formed on the chart, and howit can be identified. We will then look at the other important con-siderations—the accompanying volume pattern and measuringimplications.
Volume plays an important confirming role in all of theseprice patterns. In times of doubt (and there are lots of those), astudy of the volume pattern accompanying the price data canbe the deciding factor as to whether or not the pattern can betrusted.Major Reversal Patterns 101
 
Most price patterns also have certain measuring techniquesthat help the analyst to determine minimum price objectives.While these objectives are only an approximation of the size ofthe subsequent move, they are helpful in assisting the trader todetermine his or her reward to risk ratio.
In Chapter 5, we'll look at a second category of patterns—the continuation variety. There we will examine triangles, flags,pennants, wedges, and rectangles. These patterns usually reflectpauses in the existing trend rather than trend reversals, and areusually classified as intermediate and minor as opposed to major.
Preliminary Points Common toAll Reversal Patterns
Before beginning our discussion of the individual major reversalpatterns, there are a few preliminary points to be considered thatare common to all of these reversal patterns.
1. A prerequisite for any reversal pattern is the existence of aprior trend.
2. The first signal of an impending trend reversal is often thebreaking of an important trendline.
3. The larger the pattern, the greater the subsequent move.
4, Topping patterns are usually shorter in duration and morevolatile than bottoms.
5. Bottoms usually have smaller price ranges and take longerto build.
6. Volume is usually more important on the upside.
The Need for a Prior Trend. The existence of a prior major trend isan important prerequisite for any reversal pattern. A market mustobviously have something to reverse. A formation occasionallyappears on the charts, resembling one of the reversal patterns. Ifthat pattern, however, has not been preceded by a trend, there isnothing to reverse and the pattern is suspect. Knowing where cer-tain patterns are most apt to occur in the trend structure is one ofthe key elements in pattern recognition.102 Chapter 5
 
A corollary to this point of having a prior trend to reverseis the matter of measuring implications. It was stated earlier thatmost of the measuring techniques give only minimum price objec-tives. The maximum objective would be the total extent of theprior move. If a major bull market has occurred and a major top-ping pattern is being formed, the maximum implication for thepotential move to the downside would be a 100% retracement ofthe bull market, or the point at which it all began.
The Breaking of Important Trendlines. The first sign of an impend-ing trend reversal is often the breaking of an important trendline.Remember, however, that the violation of a major trendline doesnot necessarily signal a trend reversal. What is being signaled is achange in trend. The breaking of a major up trendline might sig-nal the beginning of a sideways price pattern, which later wouldbe identified as either the reversal or consolidation type.Sometimes the breaking of the major trendline coincides with thecompletion of the price pattern.
The Larger the Pattern, the Greater the Potential. When we use theterm “larger,” we are referring to the height and the width of theprice pattern. The height measures the volatility of the pattern.The width is the amount of time required to build and completethe pattern. The greater the size of the pattern—that is, the widerthe price swings within the pattern (the volatility) and the longerit takes to build—the more important the pattern becomes andthe greater the potential for the ensuing price move.
Virtually all of the measuring techniques in these twochapters are based on the height of the pattern. This is the methodapplied primarily to bar charts, which use a vertical measuring cri-teria. The practice of measuring the horizontal width of a price pat-tern usually is reserved for point and figure charting. That methodof charting uses a device known as the count, which assumes aclose relationship between the width of a top or bottom and thesubsequent price target.
Differences Between Tops and Bottoms. Topping patterns are usu-ally shorter in duration and are more volatile than bottoms. Priceswings within the tops are wider and more violent. Tops usuallytake less time to form. Bottoms usually have smaller price ranges,Major Reversal Patterns 103
but take longer to build. For this reason it is usually easier and lesscostly to identify and trade bottoms than to catch market tops.One consoling factor, which makes the more treacherous toppingpatterns worthwhile, is that prices tend to decline faster than they goup. Therefore, the trader can usually make more money a lot fasterby catching the short side of a bear market than by trading thelong side of a bull market. Everything in life is a tradeoff betweenreward and risk. The greater risks are compensated for by greaterrewards and vice versa. Topping patterns are harder to catch, butare worth the effort.
Volume is More Important on the Upside. Volume should generallyincrease in the direction of the market trend and is an importantconfirming factor in the completion of all price patterns. Thecompletion of each pattern should be accompanied by a notice-able increase in volume. However, in the early stages of a trendreversal, volume is not as important at market tops. Markets have away of “falling of their own weight” once a bear move gets under-way. Chartists like to see an increase in trading activity as pricesdrop, but it is not critical. At bottoms, however, the volume pick-up is absolutely essential. If the volume pattern does not show asignificant increase during the upside price breakout, the entireprice pattern should be questioned. We will be taking a more in-depth look at volume in Chapter 7.
THE HEAD AND SHOULDERSREVERSAL PATTERN
Let’s take a close look now at what is probably the best known andmost reliable of all major reversal patterns—the head and shouldersreversal. We'll spend mote time on this pattern because it is impor-tant and also to explain all the nuances involved. Most of theother reversal patterns are just variations of the head and shoul-ders and will not require as extensive a treatment.
This major reversal pattern, like all of the others, is just afurther refinement of the concepts of trend covered in Chapter 4.Picture a situation in a major uptrend, where a series of ascendingpeaks and troughs gradually begin to lose momentum. The104 Chapter 5
uptrend then levels off for awhile. During this time the forces ofsupply and demand are in relative balance. Once this distributionphase has been completed, support levels along the bottom of thehorizontal trading range are broken and a new downtrend hasbeen established. That new downtrend now has descending peaksand troughs.
Let’s see how this scenario would look on a head and shoul-ders top. (See Figures 5.1a and b.) At point A, the uptrend is pro-ceeding as expected with no signs of a top. Volume expands onthe price move into new highs, which is normal. The corrective
Left Shoulder
 
Figure 5.la Example of a head and shoulders top. The left and rightShoulders (A and E) are at about the same height. The head (C) is higherthan either shoulder. Notice the lighter volume on each peak. The pattern iscompleted on a close under the neckline (line 2). The minimum objective isthe vertical distance from the head to the neckline projected downward fromthe breaking of the neckline. A return move will often occur back to the neck-line, which should not recross the neckline once it has been broken.Major Reversal Patterns 105
 
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Figure 5.1b A head and shoulders top. The three peaks show the headhigher than either shoulder. The return move (see arrow) back to the necklineoccurred on schedule.
dip to point B is on lighter volume, which is also to be expected.At point C, however, the alert chartist might notice that the vol-ume on the upside breakout through point A is a bit lighter thanon the previous rally. This change is not in itself of major impor-tance, but a little yellow caution light goes on in the back of theanalyst’s head.
Prices then begin to decline to point D and somethingeven more disturbing happens. The decline carries below the topof the previous peak at point A. Remember that, in an uptrend, apenetrated peak should function as support on subsequent cor-rections. The decline well under point A, almost to the previousreaction low at point B, is another warning that something maybe going wrong with the uptrend.
The market rallies again to point E, this time on evenlighter volume, and isn’t able to reach the top of the previous106 Chapter 5
 
peak at point C. (That last rally at point E will often retrace one-half to two-thirds of the decline from points C to D.) To continuean uptrend, each high point must exceed the high point of therally preceding it. The failure of the rally at point E to reach theprevious peak at point C fulfills half of the requirement for a newdowntrend—namely, descending peaks.
By this time, the major up trendline (line 1) has alreadybeen broken, usually at point D, constituting another danger sig-nal. But, despite all of these warnings, all that we know at thispoint is that the trend has shifted from up to sideways. This mightbe sufficient cause to liquidate long positions, but not necessarilyenough to justify new short sales.
The Breaking of the NecklineCompletes the Pattern
By this time, a flatter trendline can be drawn under the last tworeaction lows (points B and D), which is called a neckline (see line2). This line generally has a slight upward slope at tops (althoughit’s sometimes horizontal and, less often, tilts downward). Thedeciding factor in the resolution of the head and shoulders top is a deci-sive closing violation of that neckline. The market has now violatedthe trendline along the bottom of points B and D, has brokenunder support at point D, and has completed the requirement fora new downtrend—descending peaks and troughs. The newdowntrend is now identified by the declining highs and lows atpoints C, D, E, and F Volume should increase on the breaking ofthe neckline. A sharp increase in downside volume, however, isnot critically important in the initial stages of a market top.
The Return Move
Usually a return move develops which is a bounce back to the bot-tom of the neckline or to the previous reaction low at point D (seepoint G), both of which have now become overhead resistance.The return move does not always occur or is sometimes only avery minor bounce. Volume may help determine the size of thebounce. If the initial breaking of the neckline is on very heavytrading, the odds for a return move are diminished because theMajor Reversal Patterns 107
increased activity reflects greater downside pressure. Lighter vol-ume on the initial break of the neckline increases the likelihoodof a return move. That bounce, however, should be on light vol-ume and the subsequent resumption of the new downtrendshould be accompanied by noticeably heavier trading activity.
Summary _
Let’s review the basic ingredients for a head and shoulders top.
1. A prior uptrend.
2. A left shoulder on heavier volume (point A) followed by acorrective dip to point B.
3. A rally into new highs but on lighter volume (point C).
4. A decline that moves below the previous peak (at A) andapproaches the previous reaction low (point D).
5. A third rally (point E) on noticeably light volume that failsto reach the top of the head (at point C).
6. A close below the neckline.
7. A return move back to the neckline (point G) followed bynew lows.
What has become evident is three well defined peaks. Themiddle peak (the head) is slightly higher than either of the twoshoulders (points A and E). The pattern, however, is not completeuntil the neckline is decisively broken on a closing basis. Hereagain, the 1-3% penetration criterion (or some variation thereof)or the requirement of two successive closes below the neckline(the two day rule) can be used for added confirmation. Until thatdownside violation takes place, however, there is always the pos-sibility that the pattern is not really a head and shoulders top andthat the uptrend may resume at some point.
THE IMPORTANCE OF VOLUME
The accompanying volume pattern plays an important role in thedevelopment of the head and shoulders top as it does in all price108 Chapter 5
 
patterns. As a general rule, the second peak (the head) should takeplace on lighter volume than the left shoulder. This is not arequirement, but a strong tendency and an early warning ofdiminishing buying pressure. The most important volume signaltakes place during the third peak (the right shoulder). Volumeshould be noticeably lighter than on the previous two peaks.Volume should then expand on the breaking of the neckline,decline during the return move, and then expand again once thereturn move is over.
As mentioned earlier, volume is less critical during the com-pletion of market tops. But, at some point, volume should begin toincrease if the new downtrend is to be continued. Volume plays amuch more decisive role at market bottoms, a subject to be dis-cussed shortly. Before doing so, however, let’s discuss the measur-ing implications of the head and shoulders pattern.
FINDING A PRICE OBJECTIVE
The method of arriving at a price objective is based on the height ofthe pattern. Take the vertical distance from the head (point C) tothe neckline. Then project that distance from the point where theneckline is broken. Assume, for example, that the top of the headis at 100 and the neckline is at 80. The vertical distance, therefore,would be the difference, which is 20. That 20 points would be mea-sured downward from the level at which the neckline is broken. Ifthe neckline in Figure 5.1a is at 82 when broken, a downside objec-tive would be projected to the 62 level (82 - 20 = 62).
Another technique that accomplishes about the same task,but is a bit easier, is to simply measure the length of the first waveof the decline (points C to D) and then double it. In either case,the greater the height or volatility of the pattern, the greater theobjective. Chapter 4 stated that the measurement taken from atrendline penetration was similar to that used in the head andshoulders pattern. You should be able to see that now. Prices trav-el roughly the same distance below the broken neckline as theydo above it. You’ll see throughout our entire study of price pat-terns that most price targets on bar charts are based on the height orMajor Reversal Patterns 109
volatility of the various patterns. The theme of measuring the heightof the pattern and then projecting that distance from a breakoutpoint will be constantly repeated.
It’s important to remember that the objective arrived at is onlya minimum target. Prices will often move well beyond the objec-tive. Having a minimum target to work with, however, is veryhelpful in determining beforehand whether there is enoughpotential in a market move to warrant taking a position. If themarket exceeds the price objective, that’s just icing on the cake.The maximum objective is the size of the prior move. If the previ-ous bull market went from 30 to 100, then the maximum down-side objective from a topping pattern would be a completeretracement of the entire upmove all the way down to 30.Reversal patterns can only be expected to reverse or retrace whathas gone before them.
Adjusting Price Objectives
A number of other factors should be considered while trying toarrive at a price objective. The measuring techniques from pricepatterns, such as the one just mentioned for the head and shoul-ders top, are only the first step. There are other technical factorsto take into consideration. For example, where are the prominentsupport levels left by the reaction lows during the previous bullmove? Bear markets often pause at these levels. What about per-centage retracements? The maximum objective would be a 100%retracement of the previous bull market. But where are the 50%and 66% retracement levels? Those levels often provide signifi-cant support under the market. What about any prominent gapsunderneath? They often function as support areas. Are there anylong term trendlines visible below the market?
The technician must consider other technical data in try-ing to pinpoint price targets taken from price patterns. If a down-side price measurement, for example, projects a target to 30, andthere is a prominent support level at 32, then the chartist wouldbe wise to adjust the downside measurement to 32 instead of 30.As a general rule, when a slight discrepancy exists between a pro-jected price target and a clearcut support or resistance level, it’s110 Chapter 5
usually safe to adjust the price target to that support or resistancelevel. It is often necessary to adjust the measured targets fromprice patterns to take into account additional technical informa-tion. The analyst has many different tools at his or her disposal.The most skillful technical analysts are those who learn to blendall of those tools together properly.
THE INVERSE HEADAND SHOULDERS
The head and shoulders bottom, or the inverse head and shouldersas it is sometimes called, is pretty much a mirror image of the top-ping pattern. As Figure 5.2a shows, there are three distinct bot-
Left Shoulder Right Shoulder
 
Figure 5.2a Example of an inverse head and shoulders. The bottom ver-sion of this pattern is a mirror image of the top. The only significant differ-ence is the volume pattern in the second half of the pattern. The rally fromthe head should see heavier volume, and the breaking of the neckline shouldsee a burst of trading activity. The return move back to the neckline is morecommon at bottoms.Major Reversal Patterns 117
toms with the head (middle trough) a bit lower than either of thetwo shoulders. A decisive close through the neckline is also nec-essary to complete the pattern, and the measuring technique isthe same. One slight difference at the bottom is the greater ten-dency for the return move back to the neckline to occur after thebullish breakout. (See Figure 5.2b.)
The most important difference between the top and bot-tom patterns is the volume sequence. Volume plays a much morecritica] role in the identification and completion of a head andshoulders bottom. This point is generally true of all bottom pat-terns. It was stated earlier that markets have a tendency to “fall oftheir own weight.” At bottoms, however, markets require a signif-icant increase in buying pressure, reflected in greater volume, tolaunch a new bull market.
 
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 112 Chapter 5
A more technical way of looking at this difference is thata market can fall just from inertia. Lack of demand or buyinginterest on the part of traders is often enough to push a marketlower; but a market does not go up on inertia. Prices only risewhen demand exceeds supply and buyers are more aggressivethan sellers.
The volume pattern at the bottom is very similar to thatat the top for the first half of the pattern. That is, the volume atthe head is a bit lighter than that at the left shoulder. The rallyfrom the head, however, should begin to show not only anincrease in trading activity, but the level of volume often exceedsthat registered on the rally from the left shoulder. The dip to thetight shoulder should be on very light volume. The critical pointoccurs at the rally through the neckline. This signal must beaccompanied by a sharp burst of trading volume if the breakoutis for real.
This point is where the bottom differs the most from thetop. At the bottom, heavy volume is an absolutely essentialingredient in the completion of the basing pattern. The returnmove is more common at bottoms than at tops and should occuron light volume. Following that, the new uptrend should resumeon heavier volume. The measuring technique is the same as atthe top.
The Slope of the Neckline
The neckline at the top usually slopes slightly upward.Sometimes, however, it is horizontal. In either case, it doesn’tmake too much of a difference. Once in a while, however, a topneckline slopes downward. This slope is a sign of market weaknessand is usually accompanied by a weak right shoulder. However,this is a mixed blessing. The analyst waiting for the breaking ofthe neckline to initiate a short position has to wait a bit longer,because the signal from the down sloping neckline occurs muchlater and only after much of the move has already taken place. Forbasing patterns, most necklines have a slight downward tilt. A ris-ing neckline is a sign of greater market strength, but with thesame drawback of giving a later signal.Major Reversal Patterns 113
COMPLEX HEAD ANDSHOULDERS PATTERNS
A variation of the head and shoulders pattern sometimes occurswhich is called the complex head and shoulders pattern. These arepatterns where two heads may appear or a double left and rightshoulder. These patterns are not that common, but have the sameforecasting implications. A helpful hint in this regard is the strongtendency toward symmetry in the head and shoulders pattern.This means that a single left shoulder usually indicates a sing