Head and Shoulders Pattern

HEAD AND SHOULDERS

Of all the chart patterns that signal a reversal of trend, the "Head and Shoulders” is by far the best known. It often stands out sharply, and it’s almost always possible to find one of them in the process of unfolding on some chart in one’s collection. Experienced chartists are fond of it as among the most reliable of indicators, while newcomers to chart analysis seize upon it as an early opportunity to put their theories to a practical test in the market.

As in abstract art, one should not expect the picture of a Head and Shoulder closely to resemble the real thing. Over-simplified, a Head and Shoulders (right-side up, as in Figure 16) simply portray three successive rallies and reactions, with the second one reaching a higher point than either of the others. The failure of the third rally to equal the peak of the second is a warning that a major uptrend may have come to an end. Conversely, a bottom Head and Shoulders, found upside down following a declining trend, suggests that an upturn lies ahead. Let’s examine the three phases of the Head and Shoulders top in detail:

Left Shoulder

This forms when an upturn of some duration reaches a climax in a rally, which is followed by a reaction. Volume is important. It should expand materially on the rally, and contract noticeably on the reaction. Overall volume is heavy during the formation of the left shoulder.

The Head

A second rally carries the stock higher than the first one but is followed by a reaction that erases just about all the gain, leaving the price in the vicinity of the previous low. Volume is high on the rally phase, but overall volume usually is not quite so high as during the left shoulder.

Right Shoulder

A third rally fails to reach the height of the Head before another reaction sets m. The formation of a right shoulder is a decided manifestation of weakness. Yet it is in this area that most chart misreadings are apt to occur. These can be avoided if particular attention is directed to volume during the building of the right shoulder. If volume contracts noticeably on this rally, one may take it as strong evidence that the price structure has been weakened. If, however, the volume increases, beware of a false signal, no matter how ideally the picture may have been unfolding.

No Head and Shoulders should be regarded as complete until the price breaks down below a line drawn tangent with the low of the left and right shoulders. This is called the Neckline. (Some advanced students believe it makes some difference in degree whether the Neckline slants up or down, or is horizontal, but this is debatable, and in any case, need not concern us here.)

Once the Head and Shoulders are completed, more often than not a rally will carry the price back to the Neckline. This is called the Return Move. Whether a stock will make such a move often depends on conditions in the general market. If the market as a whole is turning strongly upward, a return move in the stock is quite likely. On the other hand, if the general tone is soft, there may be no return move. The same applies to trends of the industry that includes this stock: if it’s an oil, and the oils are rallying, we may look for a return move, etc. Since outside factors must be considered, it’s not feasible to set down a hard and fast rule.