Friday, July 12, 2013

Spatial Pattern Recognition Skills and Technical Analysis for H&S Tops Part 2

MetaStock SPRS Series - Week 127 - TechniTrader® Stock Discussion for MetaStock Users - Spatial Pattern Recognition Skills and Technical Analysis for H&S Tops Part 2 - July 12, 2013
By: Martha Stokes C.M.T.

We are continuing our discussion of topping formations. Last week’s analysis was asking the question of whether the S&P 500 was a true Head and Shoulders Topping formation, or whether it was not an H&S Top and why.

A Head and Shoulders Topping Formation is a very old style of top which used to form frequently before the PC industry and computer technology revolutionized the financial services industry. It formed because the market had only 3-4 market participant groups and these groups were easily seen in the charts. H&S Tops were the culmination of the “smart money” as they were called decades ago, starting to rotate out prior to a major topping and subsequent bear or correction.

The criteria of the classic text book H&S Topping Formation was:
  1. A Stock or an Index that had been trending upward, typically a long term trend as these were mostly considered longer term tops in a market where most investors were holding for many years.

  2. The left shoulder formed on strong volume with some speculation in the price action, meaning volume began to not lead price.

  3. The head was often 2-4 times the height of the left shoulder, and as price rose volume steadily declined. A key element was the height of the head Angle of Ascent, and the declining volume. The head for a text book perfect H&S formed on lower upside volume, lower than the volume present for the left shoulder.

  4. The right shoulder was at about the same level or lower than the left shoulder. So the highest high of the right shoulder should be lower than the left for a text book perfect H&S pattern. The right shoulder formed on significantly lower volume than the head.

  5. The neckline was determined to connect the trough from the left shoulder prior to the head formation and the head trough to the right shoulder. At times the neckline is horizontal and at times it is angled downward.

  6. The high of the head down to the neckline center is the classic text book estimate of the correction for a H&S Top. This means that the pattern was supposed to represent how far the correction or bear market would go for the top.
Answers to last week's discussion:

The S&P 500 pattern is not a true Head and Shoulders Top. The left shoulder is barely identifiable as a shoulder. The “head” is very shallow, too shallow for a true text book pattern. The right “shoulder” is not a true shoulder as it has no true peak to price, and it forms too high on the head for a true H&S pattern. The index quickly recovers as it finds support at the prior lows of the sideways action that some may interpret as a left shoulder. It rebounds well to test what is now resistance from the prior step down pattern.

In addition, volume doesn’t decline for the head formation or the right shoulder and in fact, High Frequency Trader HFT volume patterns disrupt volume during the topping formation.

This is not a true Head and Shoulders Top. Why is this important to recognize? Because too often retail traders see a pattern like this and assume it is the older style Head and Shoulders pattern. They attempt to located a neckline and then calculate the downside only to sell short into a rebounding index pattern.

The reason the Head and Shoulders Tops are no longer common or reliable even when they do form, is the fact that there are now 9 Market Participant Groups active in the stock market. At the time the original Head and Shoulders Top was identified, documented, and then written about in numerous technical analysis books there were only 3 Market Participant Groups.

The addition to Dark Pools, High Frequency Traders, Professional Independent Traders, Retail Traders, and Small Funds create a much more dynamic and diverse marketplace. These new groups have altered traditional technical patterns and have created entirely new technical patterns not seen before.

Often times when a true Head and Shoulders pattern starts to form with a good solid left shoulder and a sizable Head formation, the right shoulder never forms but instead HFTs trigger and the stock or index plummets without ever forming the right shoulder.

The S&P500 weekly chart which is more often used by professionals for studying the development of potential Head and Shoulders patterns, shows clearly that this was not a short term H&S pattern.

Sometimes retail traders are so eager to try and find the older style technical patterns that they ignore the requirements for these technical patterns. It is important to not misinterpret a topping formation because it can lead to losses and riskier trades.

As a retail trader you must learn the new technical patterns that are created as 9 different Market Participant Groups trade at various times during an uptrend or downtrend.

There are many new patterns that are becoming increasingly common and are easy to identify once you learn what to watch for, as well as understanding the relationships between price, quantity, and time.

Trade wisely, 

Martha Stokes, C.M.T.
For more information email:
Member of Market Technicians Association
Master Rated Technical Analyst: Decisions Unlimited, Inc.
Instructor and Developer of TechniTrader® Stock Market Courses
MetaStock Partner
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1 comment:

Quick Draw said...

I've never had to deal with this issue. It sounds really challenging. You should ask the professionals for advice!