Mechanical systems are generally trend-following in nature, reacting to shifts in the underlying trend instead of trying to predict where the market is headed. Therefore, they do not lend themselves easily to reward estimation. Accordingly, in this chapter we shall restrict ourselves to a chart-based approach to risk and reward estimation. The patterns outlined by Edwards and Magee’ form the basis for our discussion.
The measuring objectives and risk estimates for each pattern are based on the authors’ premise that the market “goes right on repeating the same old movements in much the same old routine. While the measuring objectives are good guides and have solid historical foundations to back them, they are by no means infallible. The actual reward may under- or overshoot the expected target.
With this qualifier, we begin an analysis of the most commonly observed reversal and continuation (or consolidation) patterns, illustrating how risk and reward can be estimated in each case. First, we will cover four major reversal patterns:
1. Head-and-shoulders formation
2. Double or triple tops and bottoms
3. Saucers or rounded tops and bottoms
4. V-formations, spikes, and island tops and bottoms
Next, we will focus on the three most commonly observed continuation or consolidation patterns:
1. Symmetrical and right-angle triangles
2. Wedges
3. Flags
HEAD-AND-SHOULDERS FORMATION
Perhaps the most reliable of all reversal patterns, this formation can occur either as a head-and-shoulders top, signifying a market top, or as an inverted head-and-shoulders, signifying a market bottom. We shall concentrate on a head-and-shoulders top formation, with the understanding that the principles regarding risk and reward estimation are equally applicable to a head-and-shoulders bottom. A theoretical head-and-shoulders top formation is described in details.
This rally fails to reach the height of the head before yet another pullback occurs, setting off a right shoulder formation. If the third rally takes prices above the head at 3, we have what is known as a broadening top formation rather than a head-and-shoulders reversal. Therefore, a chartist ought not to assume that a head-and-shoulders formation is in place simply because he observes what appears to be a left shoulder and a head. This is particularly important, since broadening top formations do not typically obey the same measuring objectives as do head-and-shoulders reversals.
