Introduction What does a classic head and shoulders top look like? Is volume important in a head and shoulders top? What are the details that I should pay attention to in the head and shoulders top? How can I trade this pattern? Are there variations in the pattern that I should know about?

Introduction

The head and shoulders top is an extremely popular pattern among investors because it's one of the most reliable of all formations. It also appears to be an easy one to spot. Novice investors often make the mistake of seeing Head and Shoulders everywhere. Seasoned technical analysts will tell you that it is tough to spot the real occurrences.

The head and shoulders top is a "reversal" pattern. The formation marks a reversal in an upward trend of the stock's price - an uptrend is in the process of becoming a downtrend.

What does a classic head and shoulders top look like?

As depicted below, the classic head and shoulders top looks like a human head with shoulders on either side of the head. A perfect example of the pattern has three sharp high points, created by three successive rallies in the price of the stock.

The first point - the left shoulder - occurs as the price of the stock in a rising market hits a high and then falls back. The second point - the head - happens when prices rise to an even higher high and then fall back again. The third point - the right shoulder - occurs when prices rise again but don't hit the high of the head. Prices then fall back again once they have hit the high of the right shoulder. The shoulders are definitely lower than the head and, in a classic formation, are often roughly equal to one another.

A key element of the pattern is the neckline. The neckline is formed by drawing a line connecting two low price points of the formation. The first low point occurs at the end of the left shoulder and the beginning of the uptrend to the head. The second marks the end of the head and the beginning of the upturn to the right shoulder. The neckline can be horizontal or it can slope up or down. However, as Elaine Yager, Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors points out, a Head and Shoulders Top neckline that is sloping downwards is highly unusual and demonstrates extreme weakness.

The pattern is complete when the support provided by the neckline is "broken." This occurs when the price of the stock, falling from the high point of the right shoulder, moves below the neckline. Technical analysts will often say that the pattern is not confirmed until the price closes below the neckline - it is not enough for it to trade below the neckline.

A classic head and shoulders top has been described above. There are many variations, some of which are described here and can be just as valid as the classic formation. Other factors - including volume and the quality of the breakout - should be considered in conjunction with the pattern itself.

Is volume important in a head and shoulders top?

Volume is extremely important for this pattern.

For a head and shoulders top the volume pattern is as follows.

• Volume is highest when the left shoulder is forming. In fact, volume is often expanding as the uptrend continues and more and more buyers want to get in.
  
  
• Volume is lowest on the right shoulder as investors see a reversal happening. Experts say low volume levels on the right shoulder are a strong sign of a reversal.
  
  
• In the head portion of the price pattern, volume falls somewhere between the strength of the left shoulder and weakness of the right shoulder. Volume often increases when the neckline is broken as the reversal is now complete and downside pressure begins in earnest. In fact, Yager notes that one of the key characteristics she looks for in a Head and Shoulders Top is very high volume on the breakout.

Although volume is important, experts warn us not to get caught up in the precise number of shares being traded.¹ What we're looking for are changes in the rate of trading.

What are the details that I should pay attention to in the head and shoulders top?

There are certain characteristics that experts like to see in the pattern.

1. Symmetry - The right and left shoulders should peak at approximately the same price level. In addition, the shoulders are often about the same distance from the head. In other words, there should be about the same amount of time between the development of the top of the left shoulder and the head as between the head and the top of the right shoulder. In the real world, the formation will seldom be perfectly symmetrical. Sometimes one shoulder will be higher than the other or take more time to develop. Experts warn, however, that if a shoulder reaches the level of the head, you're no longer looking at a head and shoulders top. ²

2. Volume - The importance of volume has already been discussed. In summary, volume should be highest on the left shoulder, lowest on the right shoulder and somewhere in between on the head. The real tip-off in this formation occurs when activity fails to rally on the right shoulder.

3. Duration of the Pattern - Some experts say that an average pattern takes at least three months from start to the breakout point when the neckline is broken. It is not uncommon, however, for a pattern to last up to six months. The duration of the pattern is sometimes called the "width" of the pattern.

4. Need for an Uptrend - This is a reversal pattern which marks the transition from an uptrend in prices to a downtrend. This means that the formation always begins during an uptrend of stock prices. Yager goes further to say that she only considers a Head and Shoulders Top pattern significant if the trend has been in existence for more than a year.

5. Slope of the Neckline - The neckline can slope up or down. The direction of the slope tends to predict the severity of the price decline.³ An upward sloping neckline is considered to be more bullish than a downward sloping one, which indicates a weaker situation with more drastic price declines. However, as noted above it is rather rare to have a downward sloping neckline for this pattern.

6. Decisive Neckline Break - To be complete, the neckline must be decisively broken. If the support at the neckline holds - if price bounces around the neckline or fails to move below the neckline - this is a sign that the reversal pattern has failed. If the pattern fails to decisively break through the neckline, prices will often move higher as the rally continues. Experts advise "beware a complicated right shoulder," where prices bounce around without decisively breaking through the neckline.

How can I trade this pattern?

Begin by computing the target price. The measuring technique is as follows. Begin by computing the height of the pattern. To do this, measure the number of points vertically down from the top of the head to the neckline. Subtract this number from the point where the price finally breaks the neckline, marking the end of the right shoulder. The difference is the minimum target price.
For example, assume the top of the head is 140 and the neckline vertically under it is 110. The height of the pattern is 30 (140 - 110 = 30). Assume the neckline was broken at 80. That means the downside objective is projected at 50 (80 - 30 = 50). This target price of 50 is only a guide, affected by a variety of the other factors already mentioned. Experts remind us that this target is a minimum target.⁴ Prices will often move beyond that objective.

The way you trade this pattern will depend on how aggressive you are. No matter what your personality type, however, your trading focus will be on "breaking the neck." The pattern is not complete until the neckline is conclusively broken by the right shoulder.

On the aggressive end, Bulkowski suggests that, if you are confident that a head and shoulders formation is shaping up validly, that you should sell your stock or sell short once the right shoulder forms. He believes that because his statistics show that the pattern has a 93% success rate, there's no need to wait for a confirmed breakout before entering the trading arena.⁵
Others are less aggressive. Murphy, for example, places strong emphasis on ensuring that the pattern is complete. This can be seen by a significant breaking of the neckline, which he refers to as a "decisive closing violation" of the neckline.⁶ He argues that until that violation takes place, it's always possible that the pattern is not a head and shoulders top and that the downtrend may never take place.

Murphy advises keeping a close eye on the "return move." Sometimes, after the neckline is broken on the right shoulder, the pattern bounces back up to the neckline. This is called a return move. The return move, if it occurs at all, is often only a minor and short-lived bounce. If the neckline is broken on heavy volume, this diminishes the possibility that there will even by a return move. However, don't discount the bounce. If the price keeps hovering around the neckline without a decisive break, it may not be a head and shoulders reversal and the uptrend may resume.

Edwards and Magee call a close below the neckline break of approximately 3% of the price of the stock the "breakout" or "confirmation" of the head and shoulders top.⁷ The authors warn that up to 20% of head and shoulders tops are "saved," where prices keep bouncing around the low point of the right shoulder, before they eventually head back up.

According to Murphy, there are two tests that can be applied to determine whether the pattern is complete. He applies the 1 to 3% penetration criterion (see Edwards and Magee above) and confirms the neckline break with the "two-day rule," the requirement of the two successive closes below the neckline.⁸

Are there variations in the pattern that I should know about?

There are a few notable variations.

Watch for the Drooping Shoulder

According to Schabacker, the drooping shoulder - where neckline has a downward slope - can often indicate a rapidly developing technical weakness.⁹ The droop happens because the stock price at the end of the head and the beginning of the right shoulder have dropped even lower than the previous low at the end of the left shoulder and the beginning of the head. Most experts agree that a downward slope has bearish implications for market weakness. Typically when the right shoulder is drooping, the trader will have to wait longer than usual for a decisive neck break. Murphy points out that when that decisive break does occur much of the move will have already occurred.¹⁰

Varying Width of Shoulders

The classic head and shoulders top is symmetrical. However, if the shoulders don't match in width, don't discount the pattern. According to Schabacker, it's common for one shoulder to take longer to form than the other.¹¹ If the pattern decisively breaks the neckline, it's still a valid head and shoulders top.

Flat Shoulders

While the classic head and shoulders top is made up of three sharp upward points, these need not be present for the pattern to be valid. Sometimes, shoulders can be rounded.

Multiple Head and Shoulders Patterns

Many valid head and shoulders patterns are not as well defined as the classical head with a shoulder on either side. "Complex" formations can have more variations than the classical formation. It is not uncommon to see more than two shoulders and more than one head. Edwards and Magee advise that any combination is possible, but a multiple head and shoulders is seen more often in a head and shoulders bottom rather than a top.¹² A common version of a multiple head and shoulders pattern includes two left shoulders of more or less equal size, one head, and then two right shoulders that mimic the size and shape of the left shoulders.

¹Edwards and Magee, p. 66
²Edwards and Magee, p. 75
³Bulkowski, p. 292
⁴Murphy, p. 109
⁵Bulkowski, p. 301
⁶Murphy, p. 106
⁷Edwards and Magee, p. 64
⁸Murphy, p. 107
⁹Schabacker, p.50
¹⁰Murphy, p. 112
¹¹Schabacker, p. 47
¹²Edwards and Magee, p. 85