Breakout Patterns – Head & Shoulders (part 1/2)
Breakout patterns are used by both traders and investors to take early positions within a trend. Generally, such patterns precede big price changes and expansions in volatility. A breakout happens when an underlying asset’s price moves outside a defined support or resistance area on substantial volume. A breakout pattern trader initiates a long position after prices close above resistance or enter a short in case of a drop below support.
Typically, the most explosive price moves are a result of break of price patterns such as head & shoulders, flags-pennants and rectangles.
Structure: A Head & Shoulders forms after a strong price surge higher, and its completion marks the end of the uptrend. The pattern is made up of three consecutive peaks, with the middle peak (head) being the highest, surrounded by two lower peaks (left shoulder and right shoulder). The swing lows of each peak are connected to form a neckline, which acts as a support. The slope of the neckline is directly related to the pattern’s bearishness—a downward sloping neckline is more bearish than an upward sloping neckline.
Prior Trend: It is important that an established trend be in place before the pattern forms. Head & Shoulders patterns do not occur in range bound markets.
Volume Confirmation: In the Head & Shoulders pattern, volume plays a defining role. Ideally, volume during the formation of the left shoulder should be higher than the advance to the head. The formation of a new high on decreased volume serves as a warning sign. Final confirmation comes as volume increases during the descent from the right shoulder peak.
Head & Shoulders (part 2/2)
Break of Neckline: The pattern is complete and the uptrend reversed when the neckline support is convincingly broken on greater than average volume.
Support Turns Into Resistance: Once the neckline support is breached, it turns into a resistance for any final push from the bulls.
Target Price: The target price for a break below the neckline is found by measuring the distance from the neckline to the head, and then subtracting it from the neckline.
Bullish Formation: A bullish Head & Shoulders formation takes the opposite shape of the above scenario, resulting in a breakout higher in prices once completed.
Flag and Pennants (part 1/2)
Flags and Pennants are commonly occurring continuation structures that depict a small price consolidation prior to the resumption of the original trend.
Presence of Trend: To be considered as a valid continuation pattern, both flags and pennants should be predated by a sharp up or downward trend on heavy volume. After an underlying asset puts in a strong move, prices often pause to gather momentum for the next leg of the trend.
Structure: A flag looks like a small rectangular range that has a slope that’s against the prior trend. Since flags typically are too short in duration to have swing highs and swing lows, the price action is contained between two parallel trend lines. On the other hand, a pennant resembles a small symmetrical triangle consisting of two converging trend lines within which prices remain sandwiched. The slope can be neutral.
Flag and Pennants (part 2/2)
Breakout: A bullish breakout is signalled by a price close above the higher of the two trend lines. In case of a bearish flag or pennant pattern, a break below the lower trendline (support) indicates the previous down trend has resumed.
Volume Characteristics: Since flags and pennants are pauses within a trend, volume is considerably lower when the pattern is formed. However, the breakout should be accompanied by a substantial increase in volume to be considered legitimate.
Target Price: In case of a break above or below a flag or pennant, the resulting price moves generally equals the distance of the move that preceded the pattern.
Rectangle (part 1/2)
A Rectangle is a continuation pattern that consists of two comparable reaction highs and two comparable reaction lows. Rectangles are also often referred to as trading ranges.
Existence of Trend: To be called a valid continuation pattern, a rectangle pattern should have a prior trend.
Structure: A minimum of two equivalent swing highs are required to form an upper resistance line, and two equivalent swing lows to form the lower support line.
However, the highs and the lows need not be exactly equal price points, and can be within a reasonable proximity to one another.
Volume: Rectangles do not exhibit any standard volume patterns. The only common feature is that volume rarely increases as the pattern matures.
Rectangle (part 2/2)
Breakout Direction: Since rectangles are neutral patterns, breakouts can be in either direction.
Breakout Confirmation: To avoid jumping in on false breakouts, traders should wait for a close above or below trend lines on greater than average volume.
Return to Breakout: Once the support is breached, it turns in to resistance and vice versa, providing traders who missed the original breakout, a lower risk entry point.
Target Price: After a breakout, prices move by as much as the height of the rectangle.