The Head and Shoulders Pattern
The head and shoulder pattern may be the most valuable, because it signals a change in direction of prices.
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The head and shoulders formation is a topping patterns and has more value when it covers a long span of time, because then it projects a change in the main trend. Since major patterns encompass so much price activity, they are also hard to disguise by individual investors or even institutions. Even the specialist himself, who's job it is to control trading in the stock, can't disguise it. Still, the specialist can control the shape of the topping, or bottoming, process.
According to Ney, some specialists tend to favor the head and shoulders formation, while others prefer other patterns. There is little doubt, however, that the specialist uses the shorting tactic to throttle a strong upward move and even turn it around. The H&S chart is sometimes called a head and shoulders distribution pattern, because it shows the smart money getting out. The guys with the "smarts" are likely the specialists and corporate insiders, who see the handwriting on the wall and sell to the outsiders, namely us. The pattern indicates that insiders and big traders see trouble ahead for the company and are starting to sell their stock to still-enthusiastic buyers.
A sell signal is indicated by the pattern when, and only when, the price breaks below the so-called neckline, shown in the diagram by the red danger line. There can be many false moves to let the specialist dump as much of his inventory as he can before finally pushing prices down through the critical price line.
This is the price level many traders deem critical, so there are plenty of sell orders below the line in preparation for a breakdown in the price. The specialist has to be careful not to drop prices too early below the line, because he could get stuck with stock that others were getting rid of. Until the neckline is broken, therefore, it remains a support line, meaning it represents a concentration of demand. You can expect plenty of limit/buy orders just above the line. When the demand exceeds the supply, the line acts as a price support and prices eventually recover.
However, if there are more sellers than buyers at the red line price, the remaining sellers have to accept lower prices. Once the line has been broken, it becomes a floodgate of sales and also a line of resistance, meaning that it becomes a concentration of supply. Those who didn't sell when the line broke now want to get out, so they place limit/sell orders above the market on the expectation that prices will retrace to the line -- a phenomenon that often happens, because the specialist follows the orders up. This is what's meant by saying that prices retrace to the breakout value. There are also buy orders above the line and this gives the specialist a chance to sell more of his supply. Very clever merchandising!
The inverse (or mirror image) H&S has characteristics similar to the H&S except that it is a bottoming pattern. It is interesting to see that the major averages aren't exhibiting either of these patterns currently, yet the gold stocks are and seem to have started a long term up trend after a prolonged down trend.
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Typically, a head and shoulders top exhibits a distinctive volume pattern to go with prices. The volume tends to decline as the pattern develops.
The pattern usually begins with wide public enthusiasm and shows concomitant high volume, often climactic, on the left shoulder (LS). This is often the culmination of wave 5, in Elliott wave terminology. The price then pulls back to the neckline on light volume, to a point that can begin the first wave of an Elliott wave correction pattern and also a center point for the application of a logarithmic spiral to test for turning points further down the chart.
From this point the market surges forward again with considerable enthusiasm to a new high (H), but usually on lighter volume than on the left shoulder, though not always. On the third try, however, after another pullback to the neckline on light volume, prices move up again (RS), but not as high as before and with less excitement. By now buying enthusiasm has almost dried up, because practically all who wanted in have bought. The buying, and therefore the selling, have pretty much petered out and the price tends to drift back again to the neckline.
Now comes the major test of prices and the real interest in the stock.
If the "smart guys" have really been getting out, the price will lose its support and begin to slip below the neckline. Once that happens, sell/stops (i.e., orders to sell when the price drops below the neckline) will be triggered and an avalanche of selling will likely occur. Otherwise, the bullish trend of the stock is still intact.
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According to the theory associated with chart patterns, when a pattern breakout occurs, it is possible to get an estimate of at least a minimum objective of prices.
For the head and shoulders pattern, a minimum downside objective of prices is obtained by measuring the distance from the neckline to the top of the pattern, usually the head, and using that distance as the downside measure from the neckline.
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The topping pattern shows a purely textbook pattern of the head and shoulders topping formation, and it's just that, an idealization.
Actual charts seldom exhibit such neat characteristics, but they generally reflect the personality of the specialist in charge. Price actions are messy, and there's always doubt and hesitation, not to mention that high-volume traders tend to conceal their trading strategies. And the specialist is always maneuvering prices to maximize his profits. Therefore there are many variations of this reversal pattern. In fact, almost any version you might imagine happening could occur. But reverse is what it must eventually do, if the general consensus of the smart guys is to sell the equity, and the shape carries the marks of the specialist.
As an example, the pattern may take the form of a complex or irregular rounding shape. One common variation is that the head or the shoulders may themselves be in the shape of head and shoulders. A more regular complex structure could be more like a triple top or a horizontal channel than a head and shoulders.
In a more extreme example the neckline may be angled off the horizontal and may not even be a straight line, forming what might better be construed as back-to-back triangles, or a diamond pattern. Prices may drop below the neckline momentarily, or may not reach it at times. The pattern may be more complex than indicated, with multiple heads and/or multiple shoulders. The pattern may not be symmetric; it is often non-symmetric. Also, the volume at the head may be greater than at the left shoulder. In fact, at times it may even be a stretch to recognize the pattern for what it is.
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The head and shoulders bottom (or inverted head and shoulders) has price characteristics similar to those of head and shoulder tops, except in reverse. Prices may sell off hard on high volume to generate what becomes a panic-selling price spike low and the left shoulder. Short-sellers now begin buying in earnest to cover their positions and prices recover somewhat, to a level that will become the first measuring point of a neckline. The specialist is working feverishly now to buy stock from sellers to re-fill a depleted inventory.
From here the prices fall off again, dropping below the first spike low, with the specialist sopping up dumped stock. Prices then recover, again, and this second down-up pattern usually becomes the head. Usually the drop to the lower low occurs on decreased volume, but it needn't. The "smart" guys have started to get back in. This rise may occur on increasing volume, but the demand isn't strong enough yet to sustain prices, so they fall away again.
This time, however, price volume on the fall is light and the previous low isn't exceeded, a fact that encourages more smart-money buying. At this tine, sentiment in the stock begins to change and new buyers begin to nibble as short-sellers continue to cover their shorts, so prices rise again to form the right inverted shoulder. Now prices rise on increasing volume and the tide becomes strong enough to break through the neckline, which had become a line of resistance. Many discouraged holders of the stock had placed sell orders at the neckline. But demand is now great enough to exceed the supply and prices push through to higher values, beginning a new bullish trend.
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