Head and Shoulders
The Head and Shoulders top reversal pattern is the best performing chart pattern in a bull market, according to Bulkowski's (2005) research with an averaged maximum decline of 22%. The head and shoulders pattern consists of three "A" peaks, with the first and third peak being roughly equal in height and the second or middle peak being higher than the first and third peaks. A head and shoulder pattern has two armpits or troughs that are low prices between the first shoulder peak and the middle head peak and the middle head peak and the last shoulder peak.
Neckline - Upward Sloping
A line drawn between the two troughs is called the neckline. There are three variations of the head and shoulders pattern as it relates to this neckline: First, if the second trough is higher than the first trough, it is an upward sloping neckline.
Neckline - Downward Sloping
Second, if the second trough is lower than the first trough, then it is a downward sloping neckline; and third and most rarely, when both troughs are even in price it is a horizontal neckline.
Psychology of Head and Shoulders Pattern
The psychology of the head and shoulders pattern is explained next: The head and should pattern occurs during an uptrend, with the left shoulder being yet another higher high for the uptrend. The first trough after the left shoulder is just another expected retracement in an uptrend. From there prices continue the uptrend and make an additional high (creating the head). So far the head and shoulders pattern is not a head and shoulders pattern at all; it is just a higher high, with a short retracement downward and a second higher high in an uptrend. However, problems begin to arise either at the second trough or the right shoulder.
For a downward sloping neckline, the second trough created by the retracement after the head's higher high is far lower than expected. Since the second trough is a lower low and one definition of an uptrend states that prices make higher highs and higher lows, technically the uptrend is over and a new downtrend could be beginning. The right shoulder peak being lower than the head peak confirms the potential end of the uptrend because now there is a lower low and a lower high, one of the main definitions of a downtrend.
However, for an upward sloping neckline head and shoulders pattern, the second trough created by a retracement from the head peak is still a higher low and suggests that the uptrend is still intact. Not until the right shoulder fails to make a higher high do traders begin to worry. When the neckline is broken below on an upward sloping neckline head and shoulders pattern, essentially the upward sloping support line of the prior uptrend has been broken.
Sell Signal and Price Targets
Kirkpatrick and Dahlquist (2010) state that prices breaking through the neckline trigger the sell signal but warn never to trade in anticipation of the neckline breaking sell signal because the "risk of failure is too great"; they also suggest a price target as the height of the pattern (high price of head peak minus lowest of two troughs) subtracted from the breakout price (p. 329). However, Bulkowski (2008) suggests a smaller price target:
Traits that Increase the Head and Shoulders Pattern's Effectiveness
Traits of the head and shoulders pattern that increase its profitability (Bulkowski, 2008):
- Larger the price increase prior to pattern, greater the price reversal
- Quicker price increases prior to the pattern, increases the price reversal size
- Patterns with upward sloping lines perform best
- Higher left shoulder than right increases performance
Complex Head and Shoulders Pattern
A variation on the head and shoulders pattern is the complex head and shoulders pattern. Essentially, there are multiple left and/or right shoulders as opposed to just one left shoulder and one right shoulder.
In addition, the reverse of the head and shoulders pattern is the inverse head & shoulders pattern which is a bottom reversal pattern.
Head and Shoulders Chart Example (Downward Sloping Neckline)
The chart example above of the Mid-Cap 400 SPDR ETF (MDY) shows a head and shoulders topping pattern with a downward sloping neckline. This chart shows an uptrend with higher highs and lower lows. The left shoulder makes another new high and the first trough is a higher low. Thus far the uptrend is intact. Prices move higher making yet another new high (the head). The uptrend is still has not changed to negative, even though the head and shoulders pattern is halfway complete. Only when the retracement off of the head's highest high creates a trough that is lower than the first trough is a warning signal given that the uptrend is in trouble. A lower high (the right shoulder) confirms that the uptrend is in trouble because now there is a lower low and a lower high – one of the definitions of a downtrend. Once prices break below the neckline support area, a sell signal is given and prices fall.
Head and Shoulders Chart Example (Upward Sloping Neckline)
The chart above of Citigroup (C) shows a head and shoulders pattern that has many traits that Bulkowski (2005) suggests have an increased profitability rating: The left shoulder is higher than the right shoulder and the neckline is upward sloping.
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