Technical analysis involves the interpreting of price and volume patterns. This can be done by analyzing charts as well as using technical indicators that are mathematical manipulations of price and volume data. One of the most popular, and reliable, chart patterns is the head and shoulders pattern. This reversal pattern, when formed, signals that the security is likely to move against the previous trend.
A head and shoulders top pattern consists of three successive peaks: The middle peak, or head, is the highest and the two outside peaks, or shoulders, are lower at roughly the same level as each other. Connecting the reaction lows of each peak forms a level of support, also called the neckline.
In order for the head and shoulders top pattern to be a reversal pattern, there must be an existing upward trend to reverse. Therefore, we must first look for an existing uptrend.
During the uptrend, the left shoulder forms a peak, marking the high point of the current trend. Following the formation of this intermediate high, the price declines to complete the formation of the left shoulder. Typically, the low of this decline remains above the trendline, preserving the uptrend for the time being.
The head forms when the price reverses course and advances from the low of the left shoulder, rising above the high of the left shoulder. Following this new intermediate high, the price again declines to a level generally equal with the low of the left shoulder. This time, however, the reaction low usually breaks the uptrend, indicating that the uptrend may be at risk.
Once again, the price reverses from the low of the head, forming the right shoulder. This intermediate high is lower than the head and usually of similar height as the left shoulder. Following the formation of the right shoulder, the price again falls. However, the price does not find support and breaks below the neckline.
If you connect the two reaction lows of the left and right shoulders, you will create a support line that, for the head and shoulders pattern, is referred to as the neckline.
Depending on where these points occur, the neckline can either be horizontal or have an upward or downward slope. Some technicians believe that the most “technically sound” head and shoulders top patterns have necklines that are either horizontal or slightly upward sloping. Others believe that the slope of the neckline is an indication of the overall bearishness of the head and shoulders pattern—a downward slope is more bearish than an upward slope.
Volume is an important component of technical analysis—indicating activity and money movement. In the case of the head and shoulders top pattern, volume is a secondary, confirming indicator.
Ideally, we would like to see volume to be higher during the formation of the left shoulder than it is during the formation of the head (although it is not required). This means that the activity behind the price increase that formed the head is not as high as it was during the formation of the left shoulder. It serves as a warning that the uptrend may be losing momentum.
Another warning is if we see an increase in volume during the price decline following the formation of the head. This is an indication that selling pressure is building.
A further increase in volume following the peak of the right shoulder is additional confirmation that the uptrend is in jeopardy.
The head and shoulders top pattern is ultimately confirmed once the price breaks through the neckline, falling below the support line formed by the lows of the left shoulder and head.
A final confirmation of this violation of support is a spike in volume, ideally greater than that seen during the formation of the pattern. If the volume is lighter at the neckline break than it has been during the formation of the head and shoulders top pattern, there is a greater chance that the price will move back to and above the neckline after the initial break below it.
As we mentioned, the head and shoulders top pattern is completed when the neckline is broken. At this point, the previous uptrend is considered reversed and the price should continue its new downward course.
However, the price doesn’t always head straight down following the breakout. Sometimes, it makes what is referred to as a “throwback” move. When this happens, the price retests the neckline following the initial move downward through the neckline. This is an example of support becoming resistance, and it actually serves to strengthen the downward move, as long as the price is not able to regain levels above the neckline.
If the price retests the neckline in such a throwback move, it offers traders a second chance to sell.
Beyond signaling the end of an uptrend, traders can also use the head and shoulders top pattern to potentially gauge the extent of the corresponding reversal following the breaking of the neckline. This is useful for evaluating the potential worth of a trade as well as for setting protective stops.
To do this, we measure the distance from the neckline to the top of the head. Subtracting this distance from the neckline gives us a price target. Keep in mind that there is no guarantee that prices will fall to this level once the head and shoulders top pattern is confirmed. Instead, we should view this price target as a rough estimate.
Figure 1 shows an example of a head and shoulders pattern formed by Goldman Sachs Group Inc. (GS) during March and April of this year from StockCharts.com.
GS shares bottomed out in mid-December 2011, closing at $87.70 on December 19, and started a prolonged upward move that culminated in an intermediate high closing price of $121.13 on March 1, 2012. The price retreated to close at $113.67 on March 6, marking the end of the left shoulder.
At this point, the price resumed its uptrend to begin forming the head. The top of the head was reached on March 26, when the price closed at $126.44. During this time, with a couple of exceptions, volume was generally lower than it had been during the formation of the left shoulder.
The top of the right shoulder was formed when the price closed at $114.45 on April 10. At this point, the price again reversed course, breaking through the neckline around April 19. On this date, there was a spike in volume, albeit not as high as the trading volume two days prior.
In this example, we also see a “throwback” move by GS shares. After reaching a reaction low of $111.75 on April 23, shares retested the neckline by closing at $114.15 on May 1. After this, however, the price confirmed the reversal by entering into a downtrend that lasted into June.
Measuring the distance between the neckline and the top of the head in this example, we arrive at a value of roughly $12 ($126.44 – $114.45). When the neckline was broken at $114.45, the price target for this head and shoulders top pattern was roughly $102.45. On May 11, Goldman shares gapped down to close at $102.13. From there, the price continued to fall until closing at $91 on June 4.
When evaluating the head and shoulders top pattern, the relationship between the neckline and the top of the head serves as an indication of the potential worth of a trade if the pattern is ultimately confirmed.
Beyond the examination of the price trend, volume will help confirm the strength of the pattern and should spike when the neckline break takes place. If you don’t see confirming volume activity, the pattern—and its usefulness for predicting a successful trade—is suspect.
Even if the reversal takes place, view the projected price target as merely a guidepost and not as an absolute.