CHARTING
An Old Reliable Pattern Ñ With A Twist
A New Slant On Head And Shoulders
by Charles E. Miller
Here's a detrending technique that will help you visualize
slanted head and shoulder top patterns more clearly.
When the good old reliable head and shoulders
(H&S) pattern emerges simultaneously in the Dow Jones Industrial Average
(DJIA), the Nasdaq Composite (COMPX), and the S&P 500, it is
not a good sign. The H&S indicates that a top has been reached, and
that the market is due to head down. The display of the DJIA chart in Figure
1 is a near-perfect example of a classic head and shoulder pattern. H&S
bottom formations are just as significant, but are subject to slightly
different volume criteria.
THE HEAD AND SHOULDERS PATTERN
The H&S formation ideally consists of a series of three failed upward
moves resulting from the dynamics of interactions between buyers and sellers.
After an upward price trend, those who have ridden their stocks up will
sell and take profits. This ends the uptrend forming the left shoulder.
When the sellers are done selling and the buyers are satiated, volume contracts
and prices fall.
At some point during this pullback, a group that had missed the original
uptrend starts buying on what they perceive to be a technical reaction.
The aggregate volume during the period defined by the head is usually lower
than that of the left shoulder, and all those who bought or held at the
top are faced with losses as the prices decline to the right of the head.
Then a final and typically even smaller group of hopefuls starts buying
again.
Those who bought higher during the formation are now behind and hoping
to minimize their losses. They form a substantial overhead supply and ensure
that with a little buying pressure, prices will rise slightly. When prices
break downward through the neckline, serious selling pressure begins to
predominate, driving prices further down. Now it's a case of everybody
running for the exit, attempting to minimize his or her losses. Note the
DIJA in Figure 1 has fallen on increased volume for the month following
the downward break after completion of the right shoulder.
FIGURE 1: HEAD AND SHOULDERS PATTERN. The head and shoulders pattern is one of the more reliable predictors that show when a top has been reached.
If you filter out the higher-frequency variations using a moving average
or (as in Figure 2) a linear regression indicator, you can see that a head
and shoulders formation can be an excellent warning that a top has been
hit and a decline is imminent.
The potential to take profits or at least minimize losses is obvious.
The bad news is that you should never assume a valid H&S has formed
until the price or index has broken down through the neckline. The consequence
is that you've already lost the profit from the peak of the head back down
to the neckline. Not only that, for a horizontal neckline, you've lost
your entire trading time equal to the duration of the complete H&S
formation. And third, the nicest-looking formation during development may
simply fail to materialize as a valid H&S. This is why you should always
confirm the pattern by the final break through the neckline, coupled with
weak volume during the right shoulder.
The first objective of the H&S is that the decline reaches a level
below the neckline equal to the peak level of the head above it. That H&S
floor target was placed on the chart in Figure 3 when the index broke below
the neckline, and parallel to the neckline.
...Continued in the December 2001 issue of Technical Analysis of
STOCKS & COMMODITIES
Excerpted from an article originally published in the December
2001 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2001, Technical Analysis, Inc.
