All day I scan the charts looking for technical patterns to trade. My Trending 123 Pattern Scan powered by Recognia is one useful tool I have to scan the markets quickly, and it is showing two similarly named, but polar opposite technical events for these two biotech stocks.
Head and Shoulders Bottom
The head and shoulders bottom is a popular pattern with investors. This pattern marks a reversal of a downward trend in a financial instrument’s price.
Increasing volume at the point of breakout is absolutely crucial to a head and shoulders bottom. This increased volume definitively marks the end of the pattern and the reversal of a downward trend in the price of a stock.
A perfect example of the head and shoulders bottom has three sharp low points created by three successive reactions in the price of the financial instrument. It is essential that this pattern form following a major downtrend in the financial instrument’s price.
The first point – the left shoulder – occurs as the price of the financial instrument in a falling market hits a new low and then rises in a minor recovery. The second point – the head happens when prices fall from the high of the left shoulder to an even lower level and then rise again. The third point – the right shoulder – occurs when prices fall again but don’t hit the low of the head. Prices then rise again once they have hit the low of the right shoulder. The lows of the shoulders are definitely higher than that of the head and, in a classic formation, are often roughly equal to one another.
The neckline is a key element of this pattern. The neckline is formed by drawing a line connecting the two high price points of the formation. The first high point occurs at the end of the left shoulder and beginning of the downtrend to the head. The second marks the end of the head and the beginning of the downturn to the right shoulder. The neckline usually points down in a head and shoulders bottom, but on rare occasions can slope up.
The pattern is complete when the resistance marked by the neckline is “broken”. This occurs when the price of the stock, rising from the low point of the right shoulder moves up through the neckline. Many technical analysts only consider the neckline “broken” if the stock closes above the neckline.
The volume sequence should progress beginning with relatively heavy volume as prices descend to form the low point of the left shoulder. Once again, volume spikes as the stock hits a new low to form the point of the head. It is possible that volume at the head may be slightly lower than at the left shoulder. When the right shoulder is forming, however, volume should be markedly lighter as the price of the stock once again moves lower.
It is most important to watch volume at the point where the neckline is broken. For a true reversal, experts agree that heavy volume is essential.
Recommendation: Buy NPSP for a $9.15 – $9.30 target. Set a stop at $7.66.
Click to Enlarge United-Guardian Inc. (NASDAQ:UG) is a producer of cosmetics, pharmaceuticals and industrial products, and the company’s stock has developed a diamond top pattern over the past 47 days.
Diamond patterns usually form over several months in very active markets. Volume remains high during the formation of this pattern. The diamond top indicates a reversal to a downtrend.
The diamond top pattern occurs because prices create higher highs and lower lows in a broadening pattern. Then the trading range gradually narrows after the highs peak and the lows start trending upward.
Watch for the 200-day moving average to flatten out. Then watch for the 50-day moving average to cross below the 200-day moving average. This should signal the breakout.
Recommendation: Short UG for a $15.70 – $16.40 target. Set a stop at $21.84.
InvestorPlace advisor John Lansing tracks the charts all day and offers expert technical analysis in his day trading, options and trading services: Power Trading at the Open, Parabolic Options and Trending123. For more information on which service is for you click here.