Charting Asia

How to use head and shoulder patterns

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Chart patterns occur in all time frames. The same types of patterns can appear on one-minute charts, daily charts and weekly charts, yet the appearance of a pattern in one time frame does not foreshadow the appearance of the same pattern on a larger time frame.

The head and shoulder pattern we identified on the S&P 500 last week used a daily chart. In this context the head and shoulder pattern usually indicates a short-term pattern; more often than not this is a trend correction rather than a trend change. This was consistent with a technical trend correction of less than 10 percent.

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The market falls and then rallies. The rally moves higher than the peak of the right shoulder and the uptrend continues.

The daily chart is used for tactical decision making. We take profits and then wait to re-enter the market as the rebound develops. We anticipate that the previous uptrend is most likely to continue.

On a weekly chart, the head and shoulder pattern is more often an indication of a change in the trend direction. This is seen on the weekly DOW chart for 2007 which shows the pattern and the subsequent trend change. The weekly chart is used for strategic decision making; we use it to decide if we should be protecting profits and going to cash in anticipation of a major change in the trend. We expect that the uptrend has ended, so it may be several weeks or months before a new uptrend is established.

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The appearance of a head and shoulder pattern on a daily chart does not necessarily lead to the appearance of a head and shoulder pattern on a weekly chart. However, when we see it on the daily chart we also watch the weekly chart for the development of a similar pattern because there is always a danger that the daily pattern will lead the formation of a longer-term pattern. The key feature to watch is the behavior when the projected pattern price target is reached on the daily chart. A fall below this target level suggests a larger trend change may be developing, which can be confirmed with a weekly chart.

Disclosure: The writer holds an open position in the S&P Asia 50 Exchange Traded Fund.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders – He is a regular guest on CNBCAsia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.