Chapter 23 · Chart Patterns
Measuring a pattern, and judging whether it is real
Projection targets, volume confirmation, and the failure rates that decide how much a pattern is worth.
Head and shoulders
Naming a pattern is the easy part. What makes it usable is a measured target set before you enter, a volume condition that confirms it, and an honest expectation of how often it fails.
Measuring, by pattern
| Pattern | Measure | Project from |
|---|---|---|
| Head and shoulders | Head to neckline | The neckline break, downward |
| Inverse head and shoulders | Head to neckline | The neckline break, upward |
| Double top / bottom | Peak to the intervening trough | The neckline break |
| Rectangle | Height of the range | The breakout edge |
| Ascending / descending triangle | Height at the widest point | The breakout edge |
| Flag / pennant | The flagpole — the move into the pattern | The breakout, in the same direction |
| Cup and handle | Cup depth | The handle breakout, upward |
Worked: a measured move with the trade defined
A share forms a head and shoulders: left shoulder Rs 560, head Rs 620, right shoulder Rs 566, neckline Rs 540. It closes below the neckline at Rs 534.
- Height = 620 − 540 = Rs 80.
- Target = 540 − 80 = Rs 460.
- Invalidation = a close back above the right shoulder, Rs 566.
- Risk from entry = 566 − 534 = Rs 32. Reward to target = 534 − 460 = Rs 74.
- Reward-to-risk = 74 ÷ 32 = 2.3 to 1. That number, decided before entry, is what makes this a plan rather than a hope.
What volume should be doing
| Stage | Healthy volume behaviour |
|---|---|
| Forming the pattern | Declining — interest drying up |
| The breakout bar | Expanding, above the stock's own 20-day average |
| The pullback to the breakout level | Contracting — no rush to sell it back |
| Resuming the move | Expanding again |
A breakout on volume below average is the single most common reason a pattern fails. It means the level was crossed because nobody was defending it, not because anyone was pressing.
Double top
Failure rates, and what to do with them
Published studies of chart patterns — Bulkowski's is the most systematic, and his *Encyclopedia* is in our library — find that break-even failure rates for common patterns typically run in the tens of percent, and that the measured target is reached far less often than the pattern is said to 'work'.
- Expect the target to be missed as often as hit. Take partial profits before it, or accept a lower hit rate for a larger average win.
- Failure rates differ by direction. Patterns aligned with the larger trend fail less often than counter-trend ones.
- A failed pattern is information. A head and shoulders that breaks down and immediately reclaims the neckline often runs hard the other way — the sellers who acted on it are now trapped.
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