The knowledge of basic chart formations can significantly increase the probability of a successful position. There are a number of common technical patterns that can be used to identify favorable entry points. Trend lines, support, resistance and volume are fundamental to any technical assessment and there is one specific formation that historically exhibits all of these components in a clear and concise manner. This major reversal pattern was made famous by Charles Dow and has appeared in every major market top or bottom in the last 50 years. The formation I am referring to is a precursor to both market rallies and major corrections. It is accurately described as a "Head-n-Shoulders" top or bottom.

In its simplest form, the Head-n-Shoulders Top reflects the final rallies in a major uptrend, the first recovery of the following downtrend, and the potential support or breakdown area (neckline) between the upward movements. In a stage II climb, a stock will generally advance along an established trend line in a series of rallies that are interrupted by small corrections. When the move begins to lose strength, a consolidation area is formed. If the trend reverses to a significantly lower range before a recovery occurs, a pattern of peaks and valleys will begin to evolve. The initial segment of the formation (the left shoulder) is normally associated with high trading volume. Less volume will ordinarily drive the follow-through to the head of the pattern (generally a long-term high). A variation of the double-top, often near the peak of buying will occasionally develop on slow moving blue-chip issues. This patterns typically exhibits heavy upside volume, which dissipates and gradually increases as the stock rounds-over into the downtrend. The eventual recovery rally (to the right shoulder) is generally made on relatively low volume.

As with any pattern, there can be a number of small variations. For example, there may be two or more left shoulders near the same price range, or two or more right shoulders. In any case, the most important component of the formation is the neckline. When it is broken, the pattern is complete and a significant change in character often follows. During this transition, trading volume may not be significantly different but any substantial penetration of the neckline warrants immediate action. There is usually one attempt at recovery but the move almost always fails at the level of the neckline. The following drop is often the most precipitous of the entire formation and occasionally will eclipse the height of the pattern (the top of the Head to the Neckline). As the new character evolves, successive rallies commonly fail at lower highs until the overall decline is far greater than the magnitude of the initial formation.

The major differences between Head-and-Shoulders Tops and Bottoms are the time periods necessary for the pattern to mature and the trading volume associated with the development of the head (peak) of the formation. In bearish reversals, top formations are often completed in a few weeks. In contrast, significant support levels (or bottoms) generally occur over longer periods and some patterns may take months to evolve. In failing issues, the breakdown from a Head-and-Shoulders Top may not include a significant change in volume, whereas the bullish breakout from a Head-and-Shoulders Bottom must have volume confirmation. The historical traits of well known patterns demonstrates the ability to profit from their analysis and it's obvious you should never overlook the potential of a clearly formed and definitely broken trend.