Objectives - Head and Shoulders

OBJECTIVES

Having found a reversal pattern such as a Head and Shoulders, which indicates that a stock that has been rising is now likely to fall, or vice versa, we meet another important question: How far will it go?

We know enough now to get aboard the train (i.e.— buy stock for the rise, or sell short for the decline), but where do we get off? To "project the move” or "compute the objectives” calls for a diligent assessment of a number of factors. We’ll discuss these factors here in closer detail than we have seen in previous studies on the subject. It’s worth it. We can’t hit the objective of a price swing right on the nose every time, but we can with practice achieve a high batting average.

Now, a common rule of thumb applied to Head and Shoulders formations is that, once the pattern has been completed, the stock in its reversal swing will move at least as far again as the distance from the top of the head to the neckline. (See Figure 20.) This rule is well known to analysts, but it does not go far enough. Our selection of a probable objective must take into account other technical factors, such as, in the order of importance:

1.     What is the general market doing?

2.    How does the current price stand in relation to the historic price scale of our stock?

3.    Where are major levels of support or resistance to be met?

For a practice run, let’s assume that Stock XYZ has completed a well-defined Head and shoulder top. (Figure 21.) Should we sell? And if so, when do we buy back? If the setback is going to be minor and we like our stock for the long haul, it’s hardly worth selling. If the move is intermediate, we’d consider selling, but still might decide not to, because of the capital-gains tax we’d have to pay on our profits. On the other hand, if a major slump is impending, we want out. Well, let’s see. Like an airline pilot who runs down a checklist to determine whether it’s safe to take off, let’s run down our checklist (Questions (1.), (2.) and (3.) above) to see whether it’s prudent to hold or sell:

1. The market as a whole offers no decisive clue. Stocks have been moving irregularly "sideways” with considerable selectivity by the public, and our own industry group has been mixed.

2.   XYZ hit an all-time high of 95 at the top of the Head, formed a Right Shoulder, broke through the neckline at 80, and then effected a return move to 80, where it now stands. Three years ago it hit an all-time low of 10. That means that, at the top, it had risen 8 50rj in three years. Obviously then, the stock is historically high, and there is ample room to decline—or is there?

3. A long-range chart reveals that the last major area of "congestion” or "consolidation” with considerable trading occurred at 50. There is no other important support visible at a higher price. Thus, again, there is another potential support area that we discussed in a previous chapter when we noted that stocks often tend to retrace 50% of a major move and then meet support or resistance. This is easily computed. Over a period of three years, XYZ rose from 10 to 95, or 85 points. Half of 85 is 42 . Subtract that from 95, and you get 52 . Since that is relatively close to 50, where strong support is indicated, we had better rely on the latter figure.

But we have not yet considered our rule of thumb for the swing following a Head and Shoulders formation. In this case, the distance from the Head (95) to the Neckline (80) is 15 points, so that we may expect XYZ to drop to 65. And there’s a good chance that it will go to 52  or 50. On the basis of these findings, XYZ is an excellent candidate to be sold for a minimum decline of 15 points.