Chapter 8

Classic price patterns

 Classic Price Patterns
The concept of price patterns is demonstrated in Figures 8.1 and 8.2.

Figure 8.1 represents a typical market cycle in which there are three
trends:
up, sideways, and down. The sideways trend is essentially a horizontal or
transitional one, which separates the two major market movements.
Sometimes, a highly emotional market can change without warning, as in
Figure 8.2, but this rarely happens.

Consider a fast-moving train, which takes a long time to slow down and
then go into reverse; the same is normally true of financial markets.
This phenomenon is illustrated in Figure 8.3,
which shows the price action at the end of a long
rising trend. As soon as the price rises above line
BB, it is in the transitional area, although this is
apparent only sometime after the picture has
developed.
Once into the area, the price rises to line AA, which is a
resistance area. The word “resistance” is used because at
this point the price shows opposition to a further rise.

When the demand/supply relationship comes into balance

at AA, the market quickly turns in favor of the sellers
because prices react. This temporary reversal may occur
because buyers refuse to pay up for a security, or because
the higher price attracts more sellers, or for a combination
of these two reasons. The important fact is that the
relationship between the two groups is temporarily
reversed at this point.
Following the unsuccessful assault on AA, prices turn down
until line BB, known as a support level, is reached. Just as the
price level at AA reversed the balance in favor of the sellers,
so the support level BB alters the balance again.

This time, the trend moves in an upward direction, for at BB,

prices become relatively attractive for buyers who missed the
boat on the way up, while sellers who feel that the price will
again reach AA hold off.
For a while, there is a stand-off between buyers and sellers
within the confines of the area bounded by lines AA and BB.
Finally, the price falls below BB, and a major new (downward)
trend is signaled.
To help explain this concept, the contest between
buyers and sellers is like a battle fought by two
armies engaged in trench warfare. In Figure 8.4,
example a, armies A and B are facing off. Line AA
represents army A’s defense, and BB is army B’s
line of defense.
 Introducing the Rectangle

The transitional or horizontal phase separating rising

and falling price trends discussed earlier is a pattern
known as a rectangle. This corresponds to the “line”
formation developed from Dow theory. The rectangle
in Figure 8.5, marking the turning point between the
bull and bear phases, is termed a reversal pattern.
Reversal patterns at market tops are known as distribution areas or
patterns (where the security is “distributed” from strong, informed
participants to weak, uninformed ones), and those at market bottoms are
called accumulation patterns (where the security passes from weak,
uninformed participants to strong, informed ones. In Figure 8.6 we see a
completed pattern with a victory for the buyers as the price pushed
through line AA.
Note that as the price moves through AA, the series of
declining peaks and troughs reverses to one of rising
peaks and troughs. On the other hand, in Figure 8.7,
the price breaks to the upside, reinforcing the series
of rising peaks and troughs that precede the
formation of the rectangle, thereby reaffirming the
underlying trend.
In this case, the corrective phase associated with the formation of
the rectangle would temporarily interrupt the bull market. Such
formations are referred to as consolidation or continuation
patterns. An example of a bearish continuation rectangle is shown
in Chart 8.1 for the copper price and Chart 8.2 for the Dow Jones
Rail Average.
 Size and Depth

The principles of price pattern construction and

interpretation can be applied to any time frame,
right from one-minute bars all the way through to
monthly or even annual charts. However, the
significance of a price formation is a direct
function of its size and depth.
Major Technical Principle
The longer a pattern takes to complete,
and the greater the price fluctuations within it, the
more substantial the following move is likely to be.

Major Technical Principle

The longer the formation of any pattern
takes and the more often it fails to break through its
outer boundaries, the greater is the significance of
the ultimate penetration.
 Head and Shoulders
Head and Shoulders as Reversal Patterns
At Tops Head and shoulders (H&S) are probably the
most reliable of all chart patterns. They occur at
both market tops and market bottoms. Figure 8.21
shows a typical head-and-shoulders distribution
pattern.
It consists of a final rally (the head) separating two smaller,
although not necessarily identical, rallies
(the shoulders).

If the two shoulders were trends

of intermediate duration, the first shoulder would be the
penultimate advance in the bull market, and the second the
first bear market rally.

The head would,

Of course, represent the final intermediate rally in the bull
market.
Volume characteristics are of critical importance in assessing
the validity of these patterns.

Activity is normally heaviest during the formation of the left

shoulder and also tends to be quite heavy as prices approach
the peak.
The real tip-off that an H&S pattern is developing comes with
the formation of the right shoulder, which is invariably
accompanied by distinctly lower volume.

Quite often, the level of volume contracts as the peak of the

right shoulder is reached.
The line joining the bottoms of the two shoulders is called the
neckline.
If you look carefully at Figure 8.21, you will appreciate
that the violation of the neckline also represents a signal
that the previous series of rising peaks and troughs has
now given way to at least one declining peak and trough.

The right shoulder represents the first lower peak and

the bottom of the move following the breakdown, a
lower trough.
 Double Tops and Bottoms
A double top consists of two peaks separated by a reaction or valley in
prices. Its main characteristic is that the second top is formed with
distinctly less volume than the first (see Figure 8.28)

It is normal for both peaks to form at the same price level, but
it is also possible for the second peak to slightly exceed the
first or to top out just a little below it. Remember, this is not
an exact science, but a common sense interpretation of a
battle between buyers and sellers.

Minimum downside measuring implications for double tops, as

shown in Figure 8.28, are similar to H&S patterns.
A double bottom is shown in Figure 8.29. This type
of pattern is typically accompanied by high volume
on the first bottom, very light volume on the
second, and very heavy volume on the breakout.

Usually, the second bottom is formed above the

first, but these formations are equally valid whether
or not the second reaction reaches (or even slightly
exceeds) the level of its predecessor.
Major Technical Principle

Ultimately, it does not matter what you call a pattern

- the important thing is whether it has bullish or bearish
characteristics.