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Technical Talk: Inverted Head & Shoulders Chart Pattern
January 2nd, 2010 | 
Author: •This pattern is formed after a downtrend and is the inverse of the Head and Shoulders and is a bullish reversal.
•The pattern is comprised of three lows, the left shoulder, the head and the right shoulder.
•The first low is the left shoulder on increasing volume and then bounces up to form a reaction peak before retracing on low volume to form the head.
•The stock then makes a second reaction high which will form the neckline with the first reaction high before moving down to form the right shoulder before moving up with volume to break the neckline.
•The downtrend is failing after the Head is formed on low volume and reacts back up to form the neckline.
•The right shoulder is a higher low which confirms that the continuing bearish trend is tiring.
•When the stock moves up to challenge and break the neckline it will usually be on increased volume which will confirm the reversal of trend.
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Technical Talk: Chart Patterns – Double Top
- Chart Patterns are a “Historical Map” of the stock from a Macro perspective as represented by recognized patterns on a chart.
- The revealed pattern will allow the trader to identify the likely future direction of the stock.
- There are two broad categories of Chart Patterns 1) Reversal Patterns and 2) Continuation Patterns.
- It will take some practice to become competent at pattern recognition, but once achieved, it will be a skill that will serve you well.
- The stock market is traded by human beings. Even in an attempt to remove emotion and psychology from the market through program trading the human element is present and visible on the chart.
- Programs are designed by humans and buy/sell triggers are input to reflect specific market conditions such as perceived support or resistance.
- As chartists, we can see the psychology of the market through Chart Patterns as well as other technical analysis tools.
Reversal Chart Patterns & Psychology
Reversal chart patterns are those that denote the end of a trend and the beginning of a new trend.
When combined with other indicators that confirm the reversal, Reversal Chart Patterns become quite powerful in predicting a turn in the market.
Double Top
This is a bearish reversal pattern that appears at the top of a trend and is characterized by a peak followed by a pullback and then a second peak that stalls at the level of the first peak and then retraces.
Double Top Psychology
- The buyers at the top of the first peak were victims of buying from the “smart money” as they sold to the “dumb money” at the top of the trading range.
- These unfortunate buyers will usually hold, refusing to take a loss and waiting for the opportunity to unload the stock at a break even.
- When that opportunity presents itself, at the second top, selling pressure increases and drives the stock lower.
- Other knowledgeable traders who know that the “Double Top” will present an opportunity to short and will do so thereby increasing the downward move.
Technical Talk: What is a Moving Average Indicator?
An indicator is a formula when placed against price will hopefully reveal the directional bias of a stock. Last week we talked about how a simple moving average is determined. The purpose of any moving average is to smooth price action and give the trader a sense of where the stock is trending.
Moving averages are lagging indicators and are many times used to confirm direction. Major moving averages like the 20, 50 and 200 day simple can be used as areas of support and resistance. Sometimes moving averages are used for buy and sell signal when a shorter term moving average crosses over a longer term moving average.
A moving average can be adjusted to react more quickly to price movement and therefore not lag quite as much as a simple moving average. The purpose of doing this is so that the moving average can act more as a buy/sell signal. An example of this is the Weighted Moving Average. This average weights recent price action more heavily. Following is the formula for the Weighted Moving Average.
If using a 5 day weighted moving average, the most recent day’s price receives the greatest importance. The weighting would be in multiples as follows: 5+4+3+2+1 =15. Today’s price would receive a weight of 5, yesterday would receive a weight of 4 and so on. In this example, the total numerical weightings add up to 15. We then divide the total prices from the five trading days by the sum of the weights (15) to arrive at the most recent plot point for the weighted moving average. Using last week’s Simple Moving Average numbers, let’s recalculate for the weighted moving average.
Day 1 – $44.60 – 5 days ago, multiply by 1
Day 2 – $88.70 – 4 days ago, multiply by 2
Day 3 – $130.98 – 3 days ago, multiply by 3
Day 4 – $173.76 – 2 days ago, multiply by 4
Day 5 – $220.70 – today’s price, multiply by 5
Total = $658.74 / 15 = $43.92
This data point would be plotted. As each day closes, the new data point is plotted and the prior day receives less importance the older it becomes. Exponential Moving Averages are a bit more complex as it uses a constant or exponent that acts as a multiplier against the difference between one day’s price and the next. No need to panic, most charting packages have it all figured out for you. The important thing to know is that weighted or exponential moving averages take some of the lag out of the moving average and it becomes less of a trend following indicator and more of a leading indicator. Best, Robin
Technical Talk: What is a simple moving average?
What is a simple moving average and how is it computed?
The sum of all closing prices divided by the number of periods (days) being measured. The resulting and most recent data point is plotted and the oldest data point is dropped. So for example, the 5 day simple moving average comprises 5 data points and the moving average is dynamic.
- Example on the QQQQ from 11/17- 23 which included 5 trading days with a weekend between the 4th and 5th day.
- Closing prices
- Day 1 – $44.60
- Day 2 – $44.35
- Day 3 – $43.66
- Day 4 – $43.44
- Day 5 – $44.14
- Total = 220.19/5 = $44.038
- This data point would then be plotted as the most recent day in the 5 day simple moving average and what was the oldest day is dropped.
The moving average allows us to filter out “noise” and to determine the general direction or trend of the stock. Various moving averages can be employed. Some common and popular SMAs are the 5, 20, 50 and 200. Moving averages can act as levels of support and resistance and are sometimes used as buy and sell signal on crossovers. For instance when the shorter term average crosses from below to above the longer term average it could signal a bullish entry. Robin
Technical Talk: Trend Lines
-Drawing trend lines is one of the first things that a professional chartist will do. But how do we do it? There can be short term trend lines and longer term trend lines. There can be trend lines that define resistance as well as support. Do we connect the open, close, high or low? Do we need to be absolutely exact or is close good enough.
Here are the rules that I suggest when drawing trend lines. Start with finding the longer term lines and then move to shorter term trend lines. You need to have at least three definitive touches to be valid. The more touches the better and over a longer period of time. I suggest that you connect the lows of the candle for the lower trend line and the highs for the upper trend line. It is best if the lines touch exactly, but that will not always be the case.
You will begin to see obvious trend lines the more experienced you become. You will also begin to see that trend lines are a very powerful yet simple way to define support and resistance which if combined with other indicators can further enhance the strength of the support and resistance levels . Best, Robin
Risk Graphs: Short Combo
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-The Short combo is comprised of a higher strike Short Call and a lower strike Long Put in the same expiration month. The credit from the Short Call helps to finance the Long Put. As a result, the position can have very little if any debit. The strategy simulates very closely the risk profile of Short Stock, but for much less money. It is a bearish position. Study the risk graph and you should gain understanding of the risk and reward. Robin
Risk Graphs: Long Combo
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-The Long Combo, sometimes known as a Risk Reversal, is comprised of a lower strike Short Put and a higher strike Long Call. The credit from the Short Put helps to pay for the debit of the Long Call. As a result, the position can have very little if any debit. The strategy simulates very closely the risk profile of Long Stock by for much less money. It is a bullish position. Study the risk graph and you should gain understanding of the risk and reward of the position. Robin
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