The Importance of Volume

THE IMPORTANCE OF VOLUME

The accompanying volume pattern plays an important role in the development of the head and shoulders top as it does in all price patterns. As a general rule, the second peak (the head) should take place on lighter volume than the left shoulder. This is not a requirement, but a strong tendency and an early warning of diminishing buying pressure. The most important volume signal takes place during the third peak (the right shoulder). Volume should be noticeably lighter than on the previous two peaks. Volume should then expand on the breaking of the neckline, decline during the return move, and then expand again once the return move is over.

As mentioned earlier, volume is less critical during the com­pletion of market tops. But, at some point, volume should begin to increase if the new downtrend is to be continued. Volume plays a much more decisive role at market bottoms, a subject to be dis­cussed shortly. Before doing so, however, let's discuss the measur­ing implications of the head and shoulders pattern.

FINDING A PRICE OBJECTIVE

The method of arriving at a price objective is based on the height of the pattern. Take the vertical distance from the head (point C) to the neckline. Then project that distance from the point where the neckline is broken. Assume, for example, that the top of the head is at 100 and the neckline is at 80. The vertical distance, therefore, would be the difference, which is 20. That 20 points would be mea­sured downward from the level at which the neckline is broken. If the neckline in Figure 5.1a is at 82 when broken, a downside objec­tive would be projected to the 62 level (82 - 20 = 62).

Another technique that accomplishes about the same task, but is a bit easier, is to simply measure the length of the first wave of the decline (points C to D) and then double it. In either case, the greater the height or volatility of the pattern, the greater the objective. Chapter 4 stated that the measurement taken from a trendline penetration was similar to that used in the head and shoulders pattern. You should be able to see that now. Prices trav­el roughly the same distance below the broken neckline as they do above it. You'll see throughout our entire study of price pat­terns that most price targets on bar charts are based on the height or volatility of the various patterns. The theme of measuring the height of the pattern and then projecting that distance from a breakout point will be constantly repeated.

It's important to remember that the objective arrived at is only a minimum target. Prices will often move well beyond the objec­tive. Having a minimum target to work with, however, is very helpful in determining beforehand whether there is enough potential in a market move to warrant taking a position. If the market exceeds the price objective, that's just icing on the cake. The maximum objective is the size of the prior move. If the previ­ous bull market went from 30 to 100, then the maximum down­side objective from a topping pattern would be a complete retracement of the entire upmove all the way down to 30. Reversal patterns can only be expected to reverse or retrace what has gone before them.

Adjusting Price Objectives

A number of other factors should be considered while trying to arrive at a price objective. The measuring techniques from price patterns, such as the one just mentioned for the head and shoul­ders top, are only the first step. There are other technical factors to take into consideration. For example, where are the prominent support levels left by the reaction lows during the previous bull move? Bear markets often pause at these levels. What about per­centage retracements? The maximum objective would be a 100% retracement of the previous bull market. But where are the 50% and 66% retracement levels? Those levels often provide signifi­cant support under the market. What about any prominent gaps underneath? They often function as support areas. Are there any long term trendlines visible below the market?

The technician must consider other technical data in try­ing to pinpoint price targets taken from price patterns. If a down­side price measurement, for example, projects a target to 30, and there is a prominent support level at 32, then the chartist would be wise to adjust the downside measurement to 32 instead of 30. As a general rule, when a slight discrepancy exists between a pro­jected price target and a clearcut support or resistance level, it's usually safe to adjust the price target to that support or resistance level. It is often necessary to adjust the measured targets from price patterns to take into account additional technical informa­tion. The analyst has many different tools at his or her disposal. The most skillful technical analysts are those who learn to blend all of those tools together properly.

THE INVERSE HEAD AND SHOULDERS

The head and shoulders bottom, or the inverse head and shoulders as it is sometimes called, is pretty much a mirror image of the top­ping pattern. As Figure 5.2a shows, there are three distinct bottoms

Figure 5.2a Example of an inverse head and shoulders. The bottom ver­sion of this pattern is a mirror image of the top. The only significant differ­ence is the volume pattern in the second half of the pattern. The rally from the head should see heavier volume, and the breaking of the neckline should see a burst of trading activity. The return move back to the neckline is more common at bottoms.

with the head (middle trough) a bit lower than either of the two shoulders. A decisive close through the neckline is also nec­essary to complete the pattern, and the measuring technique is the same. One slight difference at the bottom is the greater ten­dency for the return move back to the neckline to occur after the bullish breakout. (See Figure 5.2b.)

The most important difference between the top and bot­tom patterns is the volume sequence. Volume plays a much more critical role in the identification and completion of a head and shoulders bottom. This point is generally true of all bottom pat­terns. It was stated earlier that markets have a tendency to "fall of their own weight." At bottoms, however, markets require a signif­icant increase in buying pressure, reflected in greater volume, to launch a new bull market.

Figure 5.2b A head and shoulders bottom. The neckline has a slight downward slant, which is normally the case. The pullback after the breakout (see arrow) nicked the neckline a bit, but then resumed the uptrend.

A more technical way of looking at this difference is that a market can fall just from inertia. Lack of demand or buying interest on the part of traders is often enough to push a market lower; but a market does not go up on inertia. Prices only rise when demand exceeds supply and buyers are more aggressive than sellers.

The volume pattern at the bottom is very similar to that at the top for the first half of the pattern. That is, the volume at the head is a bit lighter than that at the left shoulder. The rally from the head, however, should begin to show not only an increase in trading activity, but the level of volume often exceeds that registered on the rally from the left shoulder. The dip to the right shoulder should be on very light volume. The critical point occurs at the rally through the neckline. This signal must be accompanied by a sharp burst of trading volume if the breakout is for real.

This point is where the bottom differs the most from the top. At the bottom, heavy volume is an absolutely essential ingredient in the completion of the basing pattern. The return move is more common at bottoms than at tops and should occur on light volume. Following that, the new uptrend should resume on heavier volume. The measuring technique is the same as at the top.

The Slope of the Neckline

The neckline at the top usually slopes slightly upward. Sometimes, however, it is horizontal. In either case, it doesn't make too much of a difference. Once in a while, however, a top neckline slopes downward. This slope is a sign of market weakness and is usually accompanied by a weak right shoulder. However, this is a mixed blessing. The analyst waiting for the breaking of the neckline to initiate a short position has to wait a bit longer, because the signal from the down sloping neckline occurs much later and only after much of the move has already taken place. For basing patterns, most necklines have a slight downward tilt. A ris­ing neckline is a sign of greater market strength, but with the same drawback of giving a later signal.

COMPLEX HEAD AND SHOULDERS PATTERNS

A variation of the head and shoulders pattern sometimes occurs which is called the complex head and shoulders pattern. These are patterns where two heads may appear or a double left and right shoulder. These patterns are not that common, but have the same forecasting implications. A helpful hint in this regard is the strong tendency toward symmetry in the head and shoulders pattern. This means that a single left shoulder usually indicates a single right shoulder. A double left shoulder increases the odds of a dou­ble right shoulder.

Tactics

Market tactics play an important role in all trading. Not all tech­nical traders like to wait for the breaking of the neckline before initiating a new position. As Figure 5.3 shows, more aggressive traders, believing that they have correctly identified a head and shoulders bottom, will begin to probe the long side during the formation of the right shoulder. Or they will buy the first techni­cal signal that the decline into the right shoulder has ended.

Some will measure the distance of the rally from the bottom of the head (points C to D) and then buy a 50% or 66% retracement of that rally. Still others would draw a tight down trendline along the decline from points D to E and buy the first upside break of that trendline. Because these patterns are reasonably symmetrical, some will buy into the right shoulder as it approaches the same level as the bottom of the left shoulder. A lot of anticipatory buying takes place during the formation of the right shoulder. If the initial long probe proves to be profitable, additional positions can be added on the actual penetration of the neckline or on the return move back to the neckline after the breakout.

The Failed Head And Shoulders Pattern

Once prices have moved through the neckline and completed a head and shoulders pattern, prices should not recross the neckline

Figure 5.3 Tactics for a head and shoulders bottom. Many technical traders will begin to initiate long positions while the right shoulder (E) is still being formed. One-half to two-thirds pullback of the rally from points c to D, a decline to the same levels as the left shoulder at point A, or the breaking of a short term down trendline (line 1) all provide early opportunity for market entry. More positions can be added on the breaking of the neckline or the return move back to the neckline.

again. At a top, once the neckline has been broken on the down­side, any decisive close back above the neckline is a serious warn­ing that the initial breakdown was probably a bad signal, and cre­ates what is often called, for obvious reasons, a failed head and shoulders. This type of pattern starts out looking like a classic head and shoulders reversal, but at some point in its development (either prior to the breaking of the neckline or just after it), prices resume their original trend.

There are two important lessons here. The first is that none of these chart patterns are infallible. They work most of the time, but not always. The second lesson is that technical traders must always be on the alert for chart signs that their analysis is incor­rect. One of the keys to survival in the financial markets is to keep trading losses small and to exit a losing trade as quickly as possi­ble. One of the greatest advantages of chart analysis is its ability to quickly alert the trader to the fact that he or she is on the wrong side of the market. The ability and willingness to quickly recognize trading errors and to take defensive action immediately are qualities not to be taken lightly in the financial markets.

The Head And Shoulders as a Consolidation Pattern

Before moving on to the next price pattern, there's one final point to be made on the head and shoulders. We started this discussion by listing it as the best known and most reliable of the major reversal patterns. You should be warned, however, that this for­mation can, on occasion, act as a consolidation rather than a reversal pattern. When this does happen, it's the exception rather than the rule. We'll talk more about this in Chapter 6, "Con­tinuation Patterns."