Head and Shoulders

Apr 27, 2009: 11:22 PM CST

The Head and Shoulders Chart Pattern might be one of the most well-known and easiest to recognize patterns.  It’s classically known as a Reversal Top Pattern, though the less common “Inverted” Head and Shoulders Pattern is known as a Bottom Reversal Pattern.

The Head and Shoulders Pattern (H&S) forms after a large uptrend when price is forming a “topping” pattern of declining strength.  Below is a good example of the pattern which preceded the absolute top in the particular stock:

Head and Shoulders Chart Pattern Example

Price formed an initial rally and retracement that later became the Left Shoulder before finding support and rallying to new highs to form what later became the “Head” and then price fell back to trade at the support from the prior low.  At this point, we might suspect we have a H&S pattern but we would need to wait for a lower high to form which would make up the right shoulder to complete the pattern.

Indeed price does form a lower high and comes back to trade at the neckline, or the horizontal line that connected the various price lows.  Only then can we trade the pattern with any confidence.

How to Trade a Head and Shoulders

Once you see the three swings that comprise a H&S pattern, you can sell-short once price trades beneath the “Neckline” support level and place a stop above the swing high of the Right Shoulder.

What’s interesting about the H&S pattern is that it has a built-in “Measuring Objective” or “Price Projection Target” when price breaks beneath the support line of the neck.  Traditionally, we would measure the distance from the Head to the Neckline and then take this distance and subtract it from the Neckline once price breaks below it for a Price Objective.

If the Head peaks at $100 and the Neckline is established at $80, then once the price breaks below the Neckline out of the Right Shoulder, we would then subtract $20 (the distance from the Head to the Neckline) from $80 (the Neckline) to give us a price projection target of $60.  The blue dotted vertical lines represent the Measuring Objective on the chart above.

Volume and Psychology Insights

Analyzing Volume can help you confirm the pattern as it is developing, which can raise your confidence of having a higher probabily trade.  Keep in mind that as the Left Shoulder is forming, investors are bullish and may be aggressively participating (buying) the stock, so we would expect to see enthusiasm and high volume forming on the Left Shoulder – nothing seems amiss.

The Head forms a higher high which is promising to the Buyers, but often we observe a divergence in volume and perhaps momentum oscillators as well.  While price is making a higher high, fewer shares are being exchanged and the process of “Distribution” may be underway.  Remember a rally needs buyers to keep it going, and price can rise with lower volume, but that is a clear warning sign that something is not right – or what is known as a “Divergence” or “Non-Confirmation.”

The Right Shoulder forms a lower swing high and often we see far less volume here than on the Left Shoulder or perhaps the Head.  Investors might begin to recognize this classic pattern forming and may be preparing themselves to sell should price break the horizontal support line that has been established.  There may still be bullish sentiment present, but it may be reduced over the enthusism that created the “Head” or absolute price peak.

Once price manages to break beneath the known support line (the Neck), many aggressive traders will begin shorting at this point and those holding positions will likely begin selling them, which can create a surge of volume along with a quick acceleration of price to the downside as more and more investors begin to suspect the stock has put in a top.

In short, expect to see high optimism and high volume on the left shoulder, reduced volume and high to moderate optimism on the Head, and reduced volume and skeptical if not moderate optimism on the Right Shoulder and then a flight to exit (or establish a short trade) once price breaks the neckline which should be confirmed with a spike or rise in volume.

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