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HEAD & SHOULDERS


QQQs 24-Hour Head and Shoulders Top

05/04/01 08:21:14 AM
by David Penn

Whether you're looking at a weekly chart or a five-minute chart, a head and shoulders top spells trouble for the bulls.

Security:   QQQ
Position:   N/A

Recently I've been spending a great deal of time with intraday charts. Of course, one of the advantages of looking for chart patterns on intraday charts is that there is so much more data to search through. While a head and shoulders top, for example, may take weeks or months to form on a daily chart, an intraday chart--such as the five minute chart used in this example--can reveal its own head and shoulders top in as little as 24 hours.

This particular head and shoulders top emerged during one of the incessant rallies in the Nasdaq Unit Trust, or QQQs. I had been watching the Nasdaq rally in April--in fact, I was watching the rally approach a major downtrend line--looking for signs of breakdown. When the Nasdaq moved up on the morning of April 26th, then corrected during the lunchtime lull, only to advance again in the afternoon, I noted that what I thought might have been a double top was in fact a developing head and shoulders pattern that had actually begun late the day before.

Note the pullback just after the neckline is penetrated. Make sure your stops aren't so close as to force you out of what would otherwise be a profitable trade.
Graphic provided by: TradeStation.
 
The chart above shows the completed head and shoulders pattern from late in the day on April 25th to the end of trading on April 26th. The neckline for the formation, at 45, is almost horizontal, and the downside breakout is significant. Using the standard measurement rule of subtracting the value of the height of the formation from the value at the neckline, a downside move of 0.75 was expected. QQQs, by the end of the day, were trading around 44, providing for a full, one point breakout.

A few things are interesting about the QQQs downside breakout. First, notice how prices pull back three bars after breaking out. While there are some patterns and some trendline situations that may be more prone to pullbacks than others, I am increasingly of the opinion that it is ALWAYS worthwhile to be on guard against pullbacks. With more and more traders and would-be traders studying the markets from a technical perspective, it just seems all the more important to be wary of jumping on the breakout bandwagon until the move looks sustaining.

Another way to handle this uncertainty is with a carefully placed stop. If we are looking to avoid pullbacks, then a stop near the neckline would likely be hit. Some recommend placing the stop about midway between the neckline and the formation top. In this case, a stop at about 45.25 or higher (in the area of the rally that peaked at 11:55 a.m.) would have exposed a trader to 0.25 worth of risk for a potential gain of 0.75 (based on the measurement rule). Note also how the QQQs react once the downside objective of 0.75 is reached. While a short at the neckline breakout at 45 would have been profitable if the trader waited until the end of the day to cover, the rally in the three o'clock hour (15:15 on the chart) would have been a serious constitutional challenge for many traders who, having enjoyed a one point move, might have found themselves covering their short at the wrong time and giving up half the gain on that half-point reaction to the downside breakout.

Letting your profits run is always smart, but when your price objective is hit, taking profits may be wiser still.



David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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