.One thing I'm struggling with understanding is the following notion: Understand BEHAVIOR and not PATTERNS. Would someone elaborate on that? Don't behaviors manifest themselves into patterns?
This business of learning "patterns" early may be one of the reasons why struggling/failed traders are so sour on gurus and writers and so forth. Patterns are nothing new, but understanding why they form is critical to trading them successfully unless one is satisfied with random success. Schabacker made that clear a hundred years ago, and his caution was reiterated by his brother-in-law, Robert Edwards (of Edwards and Magee) when Schabacker asked him to finish his (Schabacker's) work after his (Schabacker's) death. Nonetheless, we nowadays generally look at patterns without any regard to how and why they form, which is why the claim is so often made that "they no longer work". The "flag", for example, is a retracement, and it works in the same fashion and under the same conditions that any retracement "works". To say that it no longer works is ignorant. Ditto with the pennant. The pennant is a trading range and it "works" just as a trading range works.
Perhaps the most famous example is the "head and shoulders", and that it is so often "found" without regard for the behavior that created it helps to account for all the imaginary heads-and-shoulders that one reads about in blogs and websites and posts.
Compare Bulkowski's description of a head and shoulders with a behavioral description:
Price trend: upward leading to the pattern
Shape: looks like a head perched atop two shoulders. A 3-peak pattern with the middle peak above the others. The pattern should look like a person's head and shoulders, proportional, and not lopsided.
Symmetry: the two shoulders should peak near the same price, be nearly the same distance from the head, and look similar (both wide or both narrow peaks)
Volume: highest on the left shoulder followed by the head [note this particular inconsistency with the behavioral example]. Trends downward 63% of the time.
Neckline: joins the two armpits
Confirmation: the pattern confirms as a valid one when price closes below an up-sloping neckline or below the right armpit when the neckline slopes downward
And the behavioral:
The head-and-shoulders top is a tenet of classical charting theory, one invented when trading off price action was accomplished using pencils and rulers.
It suggests that buying in a bull move is composed of three waves - smart money, dumb money and dumber money. Underneath each of these waves is drawn a 'neck-line', which represents the approximate points at which prices fade off the peak of each wave.
Wave 1 consists of smart money and forms the left shoulder. It represents the activity of a syndicate of buyers operating 'in secret', quietly accumulating shares. These buyers have a 'real reason' to pick up shares, one derived from research. These buyers are not momentum investors (as at this point there has not been enough momentum to attract their attention). As such the volume will be higher than normal but not so high that it scares buyers away. In fact, it can't be too high since buyers are only beginning to be attracted to the potential.
Wave 2 consists of dumb money and forms the head. These buyers missed the first big move up, the strength of which attracted their attention in the first place. They take advantage of the fade in prices off the peak of the left shoulder and use it to aggressively accumulate shares. This volume is typically the highest.
It is during the fade off the top of wave 2 that the syndicates responsible for the first leg up start to unload shares. Since they have been vested in the stock from the beginning, they recognize when things are getting 'frothy' and are scared by the frantic buying of the momentum crowd (who are more concerned with missing 'the next big thing'). It's sort of like the end of a party where all the suits have gone home and you are left with a bunch of milling drunks. Prices fade back to the neckline.
Wave 3 consists of dumber money and forms the right shoulder. This last group of buyers missed both waves 1 and 2 and looked at the fade in prices as yet another buying opportunity. These investors consist of both new money and those who entered positions late in the second wave and are thus sitting on paper losses. The volume in wave 3 is typically weaker than that forming the head and the left shoulder. So the rise in prices here is short lived due to the fact that it is even less grounded that the rise that formed the head.
Once prices fade off the right shoulder, the formation is confirmed when prices break below the neckline. This is where the short hammer is dropped.
Sounds like a lot of work, right? Wrong. This formation is so predictable that when a really good one is found (as you can see, there are a lot of conditions that must prevail for it exist fully) you are looking at a chance to trade with a high degree of success and a low amount of risk.
See the difference?
As for the place of this particular pattern in the SLA, it's largely irrelevant since one would be short long before the right shoulder even began to form. But, for those who get a woody whenever they see an incipient H&S, the above may increase their chances of a successful trade.
