The Head and Shoulders Reversal Pattern
posted under
Philosophy of Technical Analysis
by ceecabolos
Let's take a close look now at what is probably the best known and most reliable of all major reversal patterns—the head and shoulders reversal. We'll spend more time on this pattern because it is important and also to explain all the nuances involved. Most of the other reversal patterns are just variations of the head and shoulders and will not require as extensive a treatment.
This major reversal pattern, like all of the others, is just a further refinement of the concepts of trend covered in Chapter 4. Picture a situation in a major uptrend, where a series of ascending peaks and troughs gradually begin to lose momentum. The
uptrend then levels off for awhile. During this time the forces of supply and demand are in relative balance. Once this distribution phase has been completed, support levels along the bottom of the horizontal trading range are broken and a new downtrend has been established. That new downtrend now has descending peaks and troughs.
Let's see how this scenario would look on a head and shoulders top. (See Figures 5.1a and b.) At point A, the uptrend is proceeding as expected with no signs of a top. Volume expands on the price move into new highs, which is normal. The corrective.
dip to point B is on lighter volume, which is also to be expected. At point C, however, the alert chartist might notice that the volume on the upside breakout through point A is a bit lighter than on the previous rally. This change is not in itself of major importance, but a little yellow caution light goes on in the back of the analyst's head.
Prices then begin to decline to point D and something even more disturbing happens. The decline carries below the top of the previous peak at point A. Remember that, in an uptrend, a penetrated peak should function as support on subsequent corrections. The decline well under point A, almost to the previous reaction low at point B, is another warning that something may be going wrong with the uptrend.
The market rallies again to point E, this time on even lighter volume, and isn't able to reach the top of the previous
peak at point C. (That last rally at point E will often retrace one-half to two-thirds of the decline from points C to D.) To continue an uptrend, each high point must exceed the high point of the rally preceding it. The failure of the rally at point E to reach the previous peak at point C fulfills half of the requirement for a new downtrend—namely, descending peaks.
By this time, the major up trendline (line 1) has already been broken, usually at point D, constituting another danger signal. But, despite all of these warnings, all that we know at this point is that the trend has shifted from up to sideways. This might be sufficient cause to liquidate long positions, but not necessarily enough to justify new short sales.
The Breaking of the Neckline Completes the Pattern
By this time, a flatter trendline can be drawn under the last two reaction lows (points B and D), which is called a neckline (see line 2). This line generally has a slight upward slope at tops (although it's sometimes horizontal and, less often, tilts downward). The deciding factor in the resolution of the head and shoulders top is a decisive closing violation of that neckline. The market has now violated the trendline along the bottom of points B and D, has broken under support at point D, and has completed the requirement for a new downtrend—descending peaks and troughs. The new downtrend is now identified by the declining highs and lows at points C, D, E, and E Volume should increase on the breaking of the neckline. A sharp increase in downside volume, however, is not critically important in the initial stages of a market top.
The Return Move
Usually a return move develops which is a bounce back to the bottom of the neckline or to the previous reaction low at point D (see point G), both of which have now become overhead resistance. The return move does not always occur or is sometimes only a very minor bounce. Volume may help determine the size of the bounce. If the initial breaking of the neckline is on very heavy trading, the odds for a return move are diminished because the
increased activity reflects greater downside pressure. Lighter volume on the initial break of the neckline increases the likelihood of a return move. That bounce, however, should be on light volume and the subsequent resumption of the new downtrend should be accompanied by noticeably heavier trading activity.
Summary
Let's review the basic ingredients for a head and shoulders top.
1. A prior uptrend.
2. A left shoulder on heavier volume (point A) followed by a corrective dip to point B.
3. A rally into new highs but on lighter volume (point C).
4. A decline that moves below the previous peak (at A) and approaches the previous reaction low (point D).
5. A third rally (point E) on noticeably light volume that fails to reach the top of the head (at point C).
6. A close below the neckline.
7. A return move back to the neckline (point G) followed by new lows.
What has become evident is three well defined peaks. The middle peak (the head) is slightly higher than either of the two shoulders (points A and E). The pattern, however, is not complete until the neckline is decisively broken on a closing basis. Here again, the 1-3% penetration criterion (or some variation thereof) or the requirement of two successive closes below the neckline (the two day rule) can be used for added confirmation. Until that downside violation takes place, however, there is always the possibility that the pattern is not really a head and shoulders top and that the uptrend may resume at some point.
This major reversal pattern, like all of the others, is just a further refinement of the concepts of trend covered in Chapter 4. Picture a situation in a major uptrend, where a series of ascending peaks and troughs gradually begin to lose momentum. The
uptrend then levels off for awhile. During this time the forces of supply and demand are in relative balance. Once this distribution phase has been completed, support levels along the bottom of the horizontal trading range are broken and a new downtrend has been established. That new downtrend now has descending peaks and troughs.
Let's see how this scenario would look on a head and shoulders top. (See Figures 5.1a and b.) At point A, the uptrend is proceeding as expected with no signs of a top. Volume expands on the price move into new highs, which is normal. The corrective.
dip to point B is on lighter volume, which is also to be expected. At point C, however, the alert chartist might notice that the volume on the upside breakout through point A is a bit lighter than on the previous rally. This change is not in itself of major importance, but a little yellow caution light goes on in the back of the analyst's head.
Prices then begin to decline to point D and something even more disturbing happens. The decline carries below the top of the previous peak at point A. Remember that, in an uptrend, a penetrated peak should function as support on subsequent corrections. The decline well under point A, almost to the previous reaction low at point B, is another warning that something may be going wrong with the uptrend.
The market rallies again to point E, this time on even lighter volume, and isn't able to reach the top of the previous
peak at point C. (That last rally at point E will often retrace one-half to two-thirds of the decline from points C to D.) To continue an uptrend, each high point must exceed the high point of the rally preceding it. The failure of the rally at point E to reach the previous peak at point C fulfills half of the requirement for a new downtrend—namely, descending peaks.
By this time, the major up trendline (line 1) has already been broken, usually at point D, constituting another danger signal. But, despite all of these warnings, all that we know at this point is that the trend has shifted from up to sideways. This might be sufficient cause to liquidate long positions, but not necessarily enough to justify new short sales.
The Breaking of the Neckline Completes the Pattern
By this time, a flatter trendline can be drawn under the last two reaction lows (points B and D), which is called a neckline (see line 2). This line generally has a slight upward slope at tops (although it's sometimes horizontal and, less often, tilts downward). The deciding factor in the resolution of the head and shoulders top is a decisive closing violation of that neckline. The market has now violated the trendline along the bottom of points B and D, has broken under support at point D, and has completed the requirement for a new downtrend—descending peaks and troughs. The new downtrend is now identified by the declining highs and lows at points C, D, E, and E Volume should increase on the breaking of the neckline. A sharp increase in downside volume, however, is not critically important in the initial stages of a market top.
The Return Move
Usually a return move develops which is a bounce back to the bottom of the neckline or to the previous reaction low at point D (see point G), both of which have now become overhead resistance. The return move does not always occur or is sometimes only a very minor bounce. Volume may help determine the size of the bounce. If the initial breaking of the neckline is on very heavy trading, the odds for a return move are diminished because the
increased activity reflects greater downside pressure. Lighter volume on the initial break of the neckline increases the likelihood of a return move. That bounce, however, should be on light volume and the subsequent resumption of the new downtrend should be accompanied by noticeably heavier trading activity.
Summary
Let's review the basic ingredients for a head and shoulders top.
1. A prior uptrend.
2. A left shoulder on heavier volume (point A) followed by a corrective dip to point B.
3. A rally into new highs but on lighter volume (point C).
4. A decline that moves below the previous peak (at A) and approaches the previous reaction low (point D).
5. A third rally (point E) on noticeably light volume that fails to reach the top of the head (at point C).
6. A close below the neckline.
7. A return move back to the neckline (point G) followed by new lows.
What has become evident is three well defined peaks. The middle peak (the head) is slightly higher than either of the two shoulders (points A and E). The pattern, however, is not complete until the neckline is decisively broken on a closing basis. Here again, the 1-3% penetration criterion (or some variation thereof) or the requirement of two successive closes below the neckline (the two day rule) can be used for added confirmation. Until that downside violation takes place, however, there is always the possibility that the pattern is not really a head and shoulders top and that the uptrend may resume at some point.
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