Custom Search

Here's a way to use some specific calculations to improve the odds of trading a variation of a classic chart pattern - on an intraday basis.

BY DENNIS BOLZE

lassic" chart patterns such as triangles, flags, pennants, head-andshoulders and double bottoms are interpreted as continuation or reversal patterns that signal a move in a certain direction when they complete.

However, as more people become aware of a pattern, its effectiveness decreases. A pattern can become distorted and subject to "false breakouts" — a move in the expected direction that quickly fails and takes the market in the opposite direction. Over time, more experienced traders started using pattern setups to exploit uninformed traders trapped by false breakouts.

In a way, the head-and-shoulders (H&S) pattern is itself a failed retest. As shown, in the top pattern in Figure 1 (right), the market moves up, pulls back, then rallies again to point C, taking out the previous high. On the next pullback, price makes a pivot low (point D) at about the same level as the previous pullback low.

However, on the following rally, price fails to take out the point-C high and makes a lower pivot high at point E — a failed test of the previous (point C) high. Traders typically look to short the market when it breaks down below point D. Simple and clean, right?

Not really. In his 1935 book, Profits In The Stock Market, H. M. Gartley wrote about a pattern that has been called the "Gartley" ever since. The Gartley pattern is a failed H&S characterized by the Fibonacci relationships (see "The Fibonacci series," opposite page) of the pattern's different price swings.

The Gartley pattern follows the path of a typical H&S pattern, except that instead (in the case of an H&S top) of resulting in a downside price reversal, price turns back up. Once the H&S traders get short and price breaks below point D, the market rallies 1.272 or 1.618 times the preceding downswing to make a new high. This forces the short sellers to cover and further fuels the rally.

The Gartley pattern illustrates the difficulty of knowing whether a pattern that looks like a typical H&S pattern will actually follow through as expected or take off in the opposite direction. As a result, trading the basic H&S pattern is a 50-50 proposition at best.

The "crown" pattern is an H&S variation that uses Fibonacci relationships to better identify turning points. Also, by augmenting the crown pattern with the TIKI indicator (see "The TICK /TIKI indicator," right) and other tools, you can dramatically improve the odds associated with trading the standard H&S pattern.