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MELI Inverse Head & Shoulders Pattern

09/10/10 08:24:21 AM
by Billy Williams

Both independent thinking and being able to spot strong chart patterns can help you profit more than following the herd.

Security:   MELI
Position:   Accumulate

One of the most difficult challenges a trader faces is being able to think for themselves when the market is moving fast and extreme emotions are occurring all over the place. It's at these moments when traders find themselves experiencing varying degrees of fear and greed with only their ability to think under pressure preventing them from being swept up in the emotional maelstroms that hit when money is at stake. This is where the discipline to step outside the situation is not only invaluable but mandatory in order to be successful in the long run.

Focusing on chart patterns forming in the market allows you to zero in on what the market is doing versus what you would like it to do. This distinction allows you to focus on the market psychology that reveals itself in the market's price action through the forming of chart patterns.

Traders tend to trade in herds, watching what other traders are doing or taking advice from brokers and other professionals. To a point, this is valid, especially when you are looking to take advantage of trends that are in place. However, chart patterns not only exhibit low-risk points of entry into an established trend but also help reveal when a trend will experience a correction as well as a trend reversal. This information can be priceless over the long term when considering that profits can be locked down more effectively and, in the case of a trend reversal, can be lucrative when factoring in the possibility of entering a new trend right at the beginning of its move.

FIGURE 1: MELI. In early January and February 2010, Mercadolibre Inc. began to form an inverse head & shoulders pattern. On February 23, you see climactic volume occur, exhausting all selling before price breaks higher into a new trend on March 1.
Graphic provided by:
Inverse head & shoulders patterns are a classic bottoming pattern where the market or a particular security has experienced a strong down move before reversing to the upside (Figure 1). This pattern will begin to form as trading volume begins to dry up and sellers of a security become scarce. The pattern begins by setting a lower high followed by a lower low in price, which forms the left shoulder of the pattern. Then price will pull back to the upside and make one final lower high price point followed by a lower low price point, typically on a spike of selling volume that is the last gasp of the sellers. Price then pulls back to the upside and forms the head portion of the pattern. The final stage is the right shoulder where sellers try to regain the momentum back to the downside, but there just isn't enough selling force to push price to a lower price point.

The pattern is effective because it shows the weak point in the downward momentum where sellers are losing control of the trend before it reverses back to the upside. As a result, the success rate is extremely high, but be sure that the head portion of the pattern is lower than the left and right shoulders, entering as price breaks above the neckline on heavy volume. If you do, you will be able to know when to exit an existing position to the downside if you have one and be able to capture a new countertrend at the very beginning its new move for huge potential gain.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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Date: 09/14/10Rank: 2Comment: 

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