PurelyTechnical

INTRODUCTION: 

The head and shoulders top is the quintessential technical pattern. It is a bearish reversal pattern, the occurrence of which usually foretells the end of a major uptrend. The pattern is mainly characterized by three successive peaks, of which the middle peak (head) is the tallest while the other two (shoulders) are somewhat smaller and usually similar in size. The support line that connects the intervening troughs is called the ‘neckline’.

The head and shoulders is the most recognized technical pattern and rightly so. Technicians widely consider this to be the foremost reversal pattern, and many other reversal patterns are often thought of simply as variations of this pattern.

FORMATION

Left Shoulder and Head 

In the lead-up to a topping formation that would later turn out to be a head and shoulders top, the chartist witnesses a major uptrend wherein prices form a series of higher troughs and higher peaks (of which the last two will later be seen as the ‘left shoulder’ and the ‘head’, respectively).

During this phase, volume is often high when prices are rising and low when prices are correcting downwards, as is often the case during a rally in the markets.

One fine day, however, the technician finds that price has broken below the uptrend line. This trendline break has not come together with a rush of trading activity, but rather in a stealthy manner. The break of the trendline is a major warning sign for the technician, because it signals a change in the previous trend of higher peaks and higher troughs.

Neckline 

After the breaking of the uptrend, prices decline further and attempt to decline past the level of the most recent trough (A). However, despite the apparent change in momentum and direction, prices are not quite able to break below that level and start to rally once again, after putting in a new reaction low (B).

The support line that joins points A and B will later be known as the ‘neckline’. As prices rally from point B, they seem to find resistance around the level of the first peak (just before A) and the stock is not able to reach its most recent highs.

More significantly though, the chartist finds that the recent rally (from B) has come with markedly lower volume than that seen during the previous rallies. The chartist sees this non-confirmation as a significant finding and now, for the first time during this move, he starts to believe that a potential head and shoulders top might be looming.

Right Shoulder and Neckline Breakout 

The next step in the formation of this pattern is a breaking of the support line (neckline) of a pattern that is now recognized as a bonafide ‘head and shoulders top’. A significant change in trend is potentially on the cards and the chartist now needs to pay close attention to a couple of important details that will ascertain the validity of this pattern in the near future. One of the most important aspects that the chartist looks at is the volume trend that accompanies the neckline breakout.

While volume confirmation is more crucial during the move out of a bottom, the technician still seeks an increase in volume during the breaking of the neckline of a head and shoulders top.

Return Move 

Often, the final step in the confirmation of a head and shoulders pattern is the occurrence of a ‘return move’. However, note that the return move is more common at bottoms than at tops. After breaking the neckline, price often climbs back up and “tests” the neckline, This test should occur on light volume, representing a lack of demand, and should ideally not violate the neckline on a closing basis. If either volume is high or neckline resistance is violated, the chartist needs to consider the possibility that the pattern is about to fail.

However, if the pattern is legitimate, the neckline provides resistance and the downtrend resumes. This downtrend is often accompanied by increased trading volume, which confirms the renewed bearish interest in the chart as traders start to sell the stock short.

OTHER SIGNIFICANT ASPECTS

Volume 

The behaviour of volume during a head and shoulders top is of interest to the technician, although it is not as crucial a determinant of the pattern’s success as it is during the formation of a head and shoulders bottom.

Typically, during a head and shoulders top, the volume that is seen during the formation of the head is lighter than that seen during the formation of the left shoulder. It is important, though, to note that this is more of a guideline than a rule.

More significant, however, is the volume that is seen on the rally into the right shoulder. Since this rally is seen as an attempt to move back into the uptrend, low volume levels at this point would suggest that upward momentum is waning and that a bearish reversal may well be on the cards.

As prices decline from the right shoulder, there is ideally an increase in trading activity as the distribution phase comes to an end and price crashes through the neckline. Occasionally, there is a return move that is accompanied by light volume. This is then followed by an expansion in trading volume as the new downtrend commences in full force.

Duration of Pattern 

The head and shoulders top typically lasts several months – usually 3 to 6 months – from the time the left shoulder starts to form until the neckline breakout occurs.

Slope of Neckline 

A head and shoulders top often has a horizontal to slightly upward sloping neckline. Occasionally, with an exceptionally weak stock, the technician might see a downward sloping head and shoulders neckline.

VARIATIONS IN FORM 

As mentioned earlier, the typical head and shoulders top has a horizontal or slightly upward sloping neckline. However, other variants such as a downward sloping neckline may also be seen. There is also another variation of a different kind – the complex head and shoulders top. This variant is different in that it contains several shoulders and/or heads within the main formation.

SETTING UP THE TRADE & FINDING A PROFIT OBJECTIVE 

There are a couple of ways in which a head and shoulders pattern may be traded. Some traders tend to sell positions, or even sell short, at the neckline breakout (E). Others use a successful return move (F) as a selling opportunity. Aggressive traders even forerun a confirmation and sell short (at G) soon after price peaks at the right shoulder.

Regardless of the entry trigger, the method used to choose a target is most often the vertical distance or height method. Herein, the trader measures the vertical distance (in terms of points or percentage points) between the highs of the head (D) and the neckline (C) and then projects that distance from the level of the neckline breakout (E) to arrive at a target for the trade. Once prices start to decline, short positions are protected by placing stops just above the neckline

ILLUSTRATION 

TXN formed a complex head and shoulders top with a downward sloping neckline, in 2003-04. Leaving aside the fact that a typical H&S top comes with a horizontal or upward sloping neckline, this formation was close to textbook.

The stock had experienced a stellar uptrend that began in late-’02 with the stock at 14.0 and ended in Jan ’04 with it at 33.5.

The complex left shoulder, which topped at 31.5 and formed over Nov-Dec ‘03, saw decent trading volume.

The head, which topped at 33.5 and formed over Jan-Mar ‘04, occurred with similar to slightly lower volume than that seen during the left shoulder.

The rally into the right shoulder, which peaked at 31, was accompanied by trading volume that was lower than that seen at the previous peaks. The stock’s failure to rally past its previous highs, taken together with the lack of trading volume, would have led several technicians to consider liquidating long positions at this point.

As the stock started to decline out of the right shoulder, selling activity started to gather momentum and the stock went on to break the neckline in a spike of trading activity.

After the neckline break in late-April, the stock made a thorough test of neckline resistance in the form of a return move that lasted over the whole month of May. Although the technician would have been wary of the stock’s persistence just under the neckline she would have taken solace from the fact that volume was low during this phase, as is typically desired during the occurrence of a return move.

The target for the pattern, which was found by projecting the height of the head (33.5-27.0= 6.5 pts) from the level of the neckline break (26.5), was 20.0. This target was attained in late-July, barely 3 months after the breakout.