The Head & Shoulders (H&S) pattern is one of the most reliable chart patterns. Its conventional form is easy to recognize: a head perched in between two shoulders.
RECOGNIZING THE H&S
The “head” portion of the pattern should be noticeably higher than the shoulders — which should be roughly symmetrical.
The trend line which connects the bottoms is called the neck line, and ideally will not be pierced by any interim lows in between the initial rise through it and the final decline from the top of the right shoulder. It’s not unusual for a bounce to occur at the neckline. Price declines through the neckline are frequently followed by a back test — a brief return back to or near the neckline before continuing lower.
A H&S that comes at a new or significant high is considered a topping pattern, and is more reliable than continuation patterns — those contained within a trading range. One of the more dramatic topping patterns in recent history accurately forecast a 119-point decline for S&P 500 in August, 2011 and was a key element in our extremely successful 2011 as 2007 analog forecast.
Well-formed patterns are considered to have better predictive value. Note that the neckline on the above pattern was slightly sloped. A rising neckline is thought to produce more dramatic drop offs and is frequently accompanied by a smaller right shoulder and declining volume.
The shoulder line was very nearly parallel to the neckline — a positive. Although the right shoulder took only half as long as the left to complete, its peak was only slightly closer (in time) to the head’s peak. Again, this is quite normal.
Also, note the smaller yellow pattern contained within the head of the larger pattern. This “nesting” of patterns is not at all unusual and can help in constructing a longer-term forecast where each completing pattern instigates the next.
CALCULATING A TARGET
Calculating a H&S target is relatively straight-forward. Measure the price difference between the top of the head and the neckline directly beneath it. Subtract this amount from the price where the pattern completes (at the neckline) to determine the nominal target.
WHAT TO EXPECT
Occasionally, prices reach the precise nominal target. But, more often, other influences take over and cause prices to over- or undershoot their target.
Harmonic patterns are quite often reflected in the price relationships between peaks and targets. In the above example, the head’s top at 1370.58 was only 2 points away from a perfect 127.2% extension of the decline from the previous shoulder top (a Butterfly Pattern.)
The right shoulder peaked only 1 point away from retracing exactly 88.6% of its decline from 1370 for a nearly-perfect Bat Pattern. And, the August 9 low at 1101.54 was only 3 points from 1098 — the 261.8% extension of a well-formed Crab Pattern.
As a H&S pattern (especially one this large) is completing, enough market participants see it coming that price movement often accelerates. If TPTB wish to avoid the ensuing sell-off, drastic action by the Fed and/or its allies on the Plunge Protection Team (open market operations, quantitative easing, etc.) can be required.
Many investors will wait for a pattern to confirm before acting on it. In the case of a H&S pattern, this means a close below the neckline and/or a back test of the neckline. If it plays out, there is generally much more downside to come.
They’re not always successful, but once you start recognizing them and incorporating them into your forecasts, H&S patterns can contribute greatly to your investment returns.
H&S Patterns occur to the upside and the downside — known as the Inverted Head & Shoulders Pattern (IH&S.) For more on these, click here.