Head & Shoulders Top (Bearish Reversal)
Introduction | Formation | Other Aspects | Variations | Setting Up The Trade & Target | Illustration |
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.
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 final 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 stealth. The breaking of the trendline is an important warning sign for the technician, because it signals a change in the previous trend of higher peaks and higher troughs.
Neckline and Right Shoulder
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 climb 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 views this non-confirmation as a significant finding and, for the first time during this move, he starts to believe that a potential bearish reversal, courtesy a head and shoulders formation, might be looming.
Breaking of Neckline
The next step in the formation of this pattern is a breaking of the support line (neckline) of a pattern that is at this point 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. 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 and “tests” the neckline. This testing should ideally 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.
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. That is then followed by an expansion in trading volume as the new downtrend commences in full force.
Duration of Formation
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.
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 topping pattern may be traded. Typically, traders who hold long stock positions will sell those positions. In fact, active swing traders will even consider shorting the stock, upon a breaking of the neckline or upon a successful return move. Aggressive traders even forerun a confirmation and sell short 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 (E) and then projects that distance downwards from the level of the neckline breakout (F) to arrive at a target for the trade. Once prices start to decline, traers protect short positions by placing stops just above the neckline.
TXN formed a complex head and shoulders top with a downward sloping neckline, in 2003-04.
The stock had experienced a stellar uptrend that began in late-’02 with the stock trading at 14.0 and ended in Jan ’04 with the stock at 33.5.
A complex left shoulder, which topped at 31.5, formed during Nov-Dec ‘03 and was accompanied by decent trading volume. The head, which topped at 33.5 and formed between Jan-Mar ‘04, occurred with similar to slightly lower volume than that seen during the left shoulder.
The rally into the right shoulder, peaked at 31. As the stock started to decline out of the right shoulder, selling activity increased slightly and the stock went on to break the neckline in a spurt of trading activity. After the neckline break in late-April, the stock made a return move that lasted through the month of May.
Although the trader would have been wary of the stock’s persistence in the zone just below the neckline, he/she would have taken solace from the fact that there was no move back above the neckline.
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.
