V.1:7 (154-159): WHAT TEXTBOOKS NEVER TELL YOU by Jesse H. Thompson

WHAT TEXTBOOKS NEVER TELL YOU by Jesse H. Thompson

Post Pattern Activity

Most texts on market form or activity describe certain price patterns that occur with great frequency; these texts also define the implications of these price patterns and their potential movement. Studying "market habits" as Jesse Livermore called them can be of great value to the analyst or trader who has the capacity to interpret them. Many of these market habits are widely known and commonly referred to, yet used in isolation they can prove deficient. A rule of thumb is: To validate the implications of any such price pattern, ensuing price activity must conform to the implications of the pattern.

If a trade is based on a particular pattern and its assumed potential, a study of "post-pattern" activity may help reduce risk. After all, this constant attempt at risk reduction lies at the heart of longevity as a player on the investment field. Always seek these warning signals and heed their implications.

Head and Shoulders Formation

To illustrate this point, let's examine some examples of price pattern or behavior and the implications of "post-pattern" activity. First, we'll examine the widely known "head and shoulders" formation. Figure 1, is a normal example of a head and shoulder top pattern. Inherent, in the wide swings within a roughly established price range is a struggle for balance and dominance by the forces of supply and demand. All head and shoulders top patterns begin as in figure 2, with a primary ongoing upthrust followed by a reaction. Then as figure 3 illustrates, another upward thrust to new highs follows. Notice also in figure 3 that the next reaction almost completely retraces the last move up to new highs (between lines b. and c.). Next we see that a potential double bottom is forming, perhaps preparing for another swing up.