This column is devoted to technical analysis, which studies the supply and demand for securities
based on price activity and trading volume. Charts and indicators are used to uncover patterns that
may point to future price movements.
Head and
Shoulders Top
Pattern
Technical analysis involves the
interpreting of price and volume
patterns. This can be done by analyzing charts as well as using technical
indicators that are mathematical
manipulations of price and volume
data. One of the most popular, and
reliable, chart patterns is the head
and shoulders pattern. This reversal
pattern, when formed, signals that
the security is likely to move against
the previous trend.
The Pattern
A head and shoulders top pattern
consists of three successive peaks: The
middle peak, or head, is the highest
and the two outside peaks, or shoulders, are lower at roughly the same
level as each other. Connecting the reaction lows of each peak forms a level
of support, also called the neckline.
In order for the head and shoulders
top pattern to be a reversal pattern,
there must be an existing upward
trend to reverse. Therefore, we must
first look for an existing uptrend.
During the uptrend, the left shoulder forms a peak, marking the high
point of the current trend. Following
the formation of this intermediate
high, the price declines to complete
the formation of the left shoulder.
Typically, the low of this decline remains above the trendline, preserving
the uptrend for the time being.
The head forms when the price
reverses course and advances from
the low of the left shoulder, rising
above the high of the left shoulder.
Following this new intermediate high,
the price again declines to a level
generally equal with the low of the
left shoulder. This time, however,
the reaction low usually breaks the
uptrend, indicating that the uptrend
may be at risk.
Once again, the price reverses from
the low of the head, forming the right
shoulder. This intermediate high is
lower than the head and usually of
similar height as the left shoulder.
Following the formation of the right
shoulder, the price again falls. However, the price does not find support
and breaks below the neckline.
The Neckline
If you connect the two reaction
lows of the left and right shoulders,
you will create a support line that,
for the head and shoulders pattern, is
referred to as the neckline.
Depending on where these points
occur, the neckline can either be horizontal or have an upward or downward slope. Some technicians believe
that the most “technically sound”
head and shoulders top patterns have
necklines that are either horizontal
or slightly upward sloping. Others
believe that the slope of the neckline
is an indication of the overall bearishness of the head and shoulders
pattern—a downward slope is more
bearish than an upward slope.
Volume’s Contribution
Volume is an important component
of technical analysis—indicating
Figure 1. Example of a Head and Shoulders Pattern
Source: StockCharts.com.
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activity and money movement. In
the case of the head and shoulders
top pattern, volume is a secondary,
confirming indicator.
Ideally, we would like to see volume
to be higher during the formation of
the left shoulder than it is during the
formation of the head (although it is
not required). This means that the
activity behind the price increase that
formed the head is not as high as it
was during the formation of the left
shoulder. It serves as a warning that
the uptrend may be losing momentum.
Another warning is if we see an
increase in volume during the price
decline following the formation of
the head. This is an indication that
selling pressure is building.
A further increase in volume following the peak of the right shoulder
is additional confirmation that the
uptrend is in jeopardy.
Neckline Break
The head and shoulders top pattern
is ultimately confirmed once the price
breaks through the neckline, falling
below the support line formed by the
lows of the left shoulder and head.
A final confirmation of this violation of support is a spike in volume,
ideally greater than that seen during the formation of the pattern. If
the volume is lighter at the neckline
break than it has been during the
formation of the head and shoulders
top pattern, there is a greater chance
that the price will move back to and
above the neckline after the initial
break below it.
Throwback
As we mentioned, the head and
shoulders top pattern is completed
when the neckline is broken. At this
point, the previous uptrend is considered reversed and the price should
continue its new downward course.
However, the price doesn’t always
head straight down following the
Fourth Quarter 2012
breakout. Sometimes, it makes what
is referred to as a “throwback” move.
When this happens, the price retests
the neckline following the initial
move downward through the neckline. This is an example of support
becoming resistance, and it actually
serves to strengthen the downward
move, as long as the price is not able
to regain levels above the neckline.
If the price retests the neckline in
such a throwback move, it offers
traders a second chance to sell.
Estimating a Price Target
Beyond signaling the end of an
uptrend, traders can also use the
head and shoulders top pattern to
potentially gauge the extent of the
corresponding reversal following
the breaking of the neckline. This is
useful for evaluating the potential
worth of a trade as well as for setting
protective stops.
To do this, we measure the distance
from the neckline to the top of the
head. Subtracting this distance from
the neckline gives us a price target.
Keep in mind that there is no guarantee that prices will fall to this level
once the head and shoulders top pattern is confirmed. Instead, we should
view this price target as a rough
estimate.
An Illustration
Figure 1 shows an example of a
head and shoulders pattern formed
by Goldman Sachs Group Inc. (GS)
during March and April of this year
from StockCharts.com.
GS shares bottomed out in midDecember 2011, closing at $87.70 on
December 19, and started a prolonged upward move that culminated
in an intermediate high closing price
of $121.13 on March 1, 2012. The
price retreated to close at $113.67 on
March 6, marking the end of the left
shoulder.
At this point, the price resumed its
uptrend to begin forming the head.
The top of the head was reached on
March 26, when the price closed at
$126.44. During this time, with a
couple of exceptions, volume was
generally lower than it had been during the formation of the left shoulder.
The top of the right shoulder was
formed when the price closed at
$114.45 on April 10. At this point,
the price again reversed course,
breaking through the neckline around
April 19. On this date, there was a
spike in volume, albeit not as high as
the trading volume two days prior.
In this example, we also see a
“throwback” move by GS shares. After reaching a reaction low of $111.75
on April 23, shares retested the neckline by closing at $114.15 on May 1.
After this, however, the price confirmed the reversal by entering into a
downtrend that lasted into June.
Measuring the distance between
the neckline and the top of the head
in this example, we arrive at a value
of roughly $12 ($126.44 – $114.45).
When the neckline was broken at
$114.45, the price target for this head
and shoulders top pattern was roughly
$102.45. On May 11, Goldman shares
gapped down to close at $102.13.
From there, the price continued to fall
until closing at $91 on June 4.
Conclusion
When evaluating the head and
shoulders top pattern, the relationship between the neckline and the
top of the head serves as an indication of the potential worth of a trade
if the pattern is ultimately confirmed.
Beyond the examination of the
price trend, volume will help confirm the strength of the pattern and
should spike when the neckline break
takes place. If you don’t see confirming volume activity, the pattern—and
its usefulness for predicting a successful trade—is suspect.
Even if the reversal takes place,
view the projected price target as
merely a guidepost and not as an
absolute.
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