Chart Patterns: Head and Shoulders

Introduction:    

We discussed important concepts common to chart patterns in a previous article. Having laid the foundation, we now focus on a very popular reversal pattern called the “Head and Shoulders”. Remember that reversal patterns are found at the end of a major trend, while continuation patterns form within a trend. 

The head and shoulders consolidation is composed of three humps: the apex of the prior rally known as the head, and two lower peaks called shoulders, one on either side of the head. I like to use the abbreviation “SHS” for shoulder-head-shoulder.    

Like most reversal patterns, the SHS occurs both at the top and bottom 1 of a trend in somewhat mirror images, but with some important differences. It is also worth noting that SHS tend to form differently in individual stocks compared with indices. Our discussion will focus on the SHS topping pattern as it forms primarily in major indices.    

Chart Example:    

Figures 1 and 3 describe a SHS found in the Dow Jones Industrial Average during 2007. The charts plot the weekly closing price on a logarithmic scale below which the weekly volume is overlaid with a simple moving average. Please refer to figure-1 below.   

DJIA Head & Shoulders 2007

Figure-1: Dow Jones Industrial Average, 2007

The Left Shoulder:    

The wave which began in March 2007 is partially retraced by A-B on heavier and above average volume. And thus the left shoulder is formed.  Volatility rises noticeably. And many any leading stocks are forming late stage bases which are prone to failure.   

The Head:    

The market begins a new wave B-C and sets a new high for the major uptrend, but interest is waning as evidenced by the lower volume. Point-C sets the apex of the pattern and marks the end of the 2003 cyclical bull market.    

The sell-off from C-D is again accompanied by heavier and above average volume. Unlike A-B, approximately the entire preceding rally is retraced until support is found near the level of the previous low. Volatility remains higher.   

DJIA "Head" of Head and Shoulders 2007

Figure 2: Price and volume action in the head of the pattern.

The daily bar chart in figure-2 allows a closer examination of the price and volume action during the formation of the head. Shown are three significant up days on steadily declining volume. In fact, the highest close on October 9 came on below average volume.    

The intraday high, the apex of the 2003 bull market, occurred on October 11. Volume was the highest in three weeks and well above average. The day’s swing from high to low measured 1.76% of the previous close. However, the day closed well into the lower part of its trading range.    

October 11 was by definition a key reversal day 2. The right side of the head was marked by many distribution days 3 in close proximity.    

The Neckline:    

Returning to figure-1, the two lows at points B and D form the neckline, an area of support which will become resistance when broken. Although it is common to draw support/resistance as a line through B-D, I prefer defining support/resistance levels by a horizontal area as shown in figure-1, rather than by a sloping line.    

The Right Shoulder:    

After finding support at point-D, the market rallies from D-E only to falter at resistance usually found near the peak of the left shoulder, well below the head. The market then plummets towards the neckline as volume increases sharply. Sometimes there is a small bounce at neckline support, but this is not a requirement for the pattern.    

In our example, the decline from point-E towards the neckline occurred during the Christmas holiday, skewing the volume lower. Volume was back above average after the holidays.    

Completing the Pattern:    

The SHS reversal pattern is not complete until after the neckline is decidedly breached below point-F on a closing basis. About three closes or a 3% decline below the neckline are added confirmation. On the day the neckline is unmistakably breached,  

  • the volume is preferably heavier and above average
  • the intraday price range is wide (volatile)
  • the day’s close is decidedly below the neckline

The previous rally has been squelched. Three peaks are evident defining the head and shoulders pattern. The higher highs and higher lows characteristic of the prior uptrend have been replaced with a lower high and a lower low from C-D-E through F. Occasionally, there is a minor bounce on low volume back to neckline-resistance, but this is not a requirement for the pattern.    

Price Objective:    

The height of the pattern gives us a glimpse into the degree of the impending decline. Measuring the price differential between the apex and the neckline, and subtracting it from the neckline at point-F yields the minimum price target. 4 

It is important to stress that the price target is a minimum. Prices can and often do move well beyond this target as our example later illustrates. If point-G met the price objective, point-J definitely exceeded it.   

DJIA line chart 2003-2009

Figure 3: Dow Jones Industrial Average, 2003-2009

The Larger Context:    

Figure-3 shows that our SHS was preceded by a four year uptrend which defined the major uptrend line. Volatility (VXD) settled down mostly below 17%. After mid-2006, a steeper minor uptrend emerged, which was later broken by the decline from the head. The major trend line was not broken until well after the neckline was breached.    

During the left shoulder, volatility rose suddenly through resistance, ranging approximately 15-30% for the duration of the SHS formation. Once it became obvious that this may be more than a 20% correction, volatility spiked to around 70%. But by then we were in the fourth quarter of 2008, nearly a year and some 3000 points after the head and shoulders formation. 

The Warning Signs:   Sign: Warning Steep Incline Ahead 

Harbingers of the bear appeared before the SHS pattern became evident. The preponderance of the evidence should move the trader or investor to take shelter if not take advantage. Warning signs included… 

  • The rise in volatility during the left shoulder
  • A pattern of rising volume in down legs, declining in up legs
  • Increasing distribution days in close proximity
  • Leading stocks breaking out of sloppy late stage bases and failing

Conclusion:    

It is worth repeating that the SHS forms over a period of weeks to months. Though many practitioners will point out a SHS on an intraday chart, I do not believe the rationale behind the pattern supports this practice.    

As popular as the SHS pattern is among traders, it occurs less frequently than one might think. During my experience as a trader and an active trader broker, I have heard of more SHS sightings than of Elvis. But it is reliable enough that when you spot it, take notice, and take action!

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Footnotes:

  1. The bottoming or reverse SHS is similar to the SHS top with a few important differences. The bottom SHS usually takes longer to form. A significant increase in volume is needed for a market to break out of the neckline, while a lack of buying pressure is enough to allow prices to move lower. 
  2. Reversal day: A sharp single day price reversal. In an uptrend, a new high is made only to close near the bottom of the day’s range. A wider price range and heavier volume increase the probability of a short term trend reversal. See also 03-12-03, 02-19-04, 03-07-05, 11-29-05, 07-18-06, 03-14-07, 08-16-07, 11-21-08, 02-05-2010, 06-21-2010.
  3. Distribution day: A lower close on higher volume. The larger the decline relative to average volatility and the higher the volume, then the more significant the distribution day. (Churning is a type of distribution day marked by almost no change in the day’s close.) See also in 2010 04-06, 04-27, 04-30, 05-04, 05-06, 05-07, 05-14, 05-18, 05-20.
  4. Using volatility to determine the minimum price target is a general principal in technical analysis.  

Sources:
Murphy, John J. Technical Analysis of the Financial Markets. Paramus: NYIF, 1999
Pring, Martin J. Technical Analysis Explained, 3rd ed. McGraw Hill, 1991
O’Neil, William J. How to Make Money Selling Stocks Short. Hoboken: Wiley, 2005
Kaufman, Perry J. New Trading Systems and Methods, 4th ed. Hoboken: Wiley, 2005    


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  1. Chart Patterns: An Overview | Sargon Y. Zia, merging fundamental analysis with technical analysis — July 29, 2010 @ 4:02 pm

  2. Chart Patterns: Double-Top | Sargon Y. Zia, merging fundamental analysis with technical analysis — August 31, 2010 @ 11:41 pm

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