The Head and Shoulders Formation

One of the most dependable formations you’ll find in the market is the Head-and-Shoulders pattern. There are two versions of the formation and both can be found at market extremes. The top formation occurs at market peaks and inverse the head and shoulder formations at bottoms. They’re most widely known as a trend reversal formation but, on occasion, we have come across a head-and-shoulders consolidation. Visually, the pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected to form what is called the neckline.

As its name implies, the head and shoulders pattern is made up of a left shoulder, head, right shoulder and neckline. As with most technical formations, the pattern itself is more than just a price formation. It’s a psychological shift in investor sentiment that involves volume, the breakout, price target and support turned resistance. Let’s break the formation down into it’s component parts and then put them together with a few examples.

I. Prior Trend: It is important to establish the existence of a prior up-trend (or downtrend for an inverse head and shoulders pattern) for this to be a reversal pattern. Without a prior trend to reverse, there cannot be a head and shoulders pattern, or any reversal pattern for that matter. Understand, that a true reversal pattern forms because the mentality regarding a particular issue has shifted. The price pattern is simply the hard data to show you the shift, but the formation is truly driven by investor’s mental perceptions and their accumulation or distribution of a stock.

II. Left Shoulder: While in an up-trend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the first shoulder. The low of the decline usually remains above the trend line, keeping the up-trend intact. The left shoulder is very important because it’s what assists in defining the neckline. With an inverse head and shoulders pattern, we see the exact opposite action. Instead of setting a new high, the issue would have set a new low to start the formation on the left shoulder.

III. Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline. The low of the decline usually breaks the up-trend line, putting the up-trend in jeopardy. As we know from our technical analysis 101 classes, an up trend is defined as a series of higher highs and higher lows (and vice-versa for a downtrend). At this point in the formation, we truly don’t know that the formation is taking shape. We simply see an up trend. However, the head of the formation will end up being the exhaustive phase of the pattern. For an inverse head-and-shoulders pattern we have the exact opposite action. The head is setting a new low, which makes it appear as if the downtrend is still in tact.

IV. Right Shoulder: The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack. As with most technical formations, perfection is rarely found. But, in the end, the right shoulder should definitely be below the head and really shouldn’t retest that high in any manner. The decline from the peak of the right shoulder will confirm and define the neckline. For an inverted head-and-shoulders formation, we get the exact opposite action. The right shoulder will be a movement off the neckline that takes the stock to a shallower low than the head. Again, this gives us an early signal that the downtrend may be over.

V. Neckline: The neckline forms by connecting the low points of the right side of the right and left shoulders with the low on the head. Depending on the relationship between these lows, the neckline can slope up, slope down or be horizontal. Further, the slope of the neckline will affect the pattern's degree of bearishness: a downward slope is more bearish than an upward slope. Sometimes more than one low point can be used to form the neckline.

VI. Volume: As the head and shoulders pattern unfolds, volume plays a CRITICAL role in confirmation. As with most technical patterns, if you have “head-and-shoulders” on the brain, you can convince yourself you see them all over the place like a drunk sees pink elephants. However, to truly have success trading this pattern, you need the volume to fall into place in the correct areas. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. Although, the volume on both the first shoulder and the head should be relatively heavy. This is the exhaustive phase of the pattern. The warning sign comes when volume increases on the decline from the peak of the head. As well, the volume on the right shoulder should be very thin on the way up and increasing on the way down. With an inverted head-and-shoulders pattern, we get the exact opposite action with our volume. Volume should be very heavy on the first shoulder and the head (on the way down). This is the exhaustion selling that’s getting the weak hands out of the issue. The volume should be thinner on the left side of the right shoulder with increasing volume to the buy side as the stock progresses back toward the neckline.

VII. Neckline Break: The head-and-shoulders (or inverse head-and-shoulders pattern) is not complete and the trend is not reversed until neckline support (or resistance) is broken. Ideally, this should also occur in a convincing manner with an expansion in volume. Many technicians use two to three times average daily volume as a benchmark for volume on the day the issue breaks the neckline. As well, some traders won’t trade a pattern until the stock has closed at least 3% below the neckline. That’s not something I adhere to, but it’s worth mentioning as quite a few traders use this benchmark.

VIII. Support turned resistance: Once a support line is broken, it becomes resistance and vice versa. Once the neckline is broken in this pattern, it is common for this same support level to turn into resistance (or vice versa for a reverse head-and-shoulders pattern). Sometimes, but certainly not always, the price will return to the support break and offer a second chance to trade the formation.

IX. Price Target: After breaking neckline support (resistance), the projected price decline (advance) is found by measuring the distance from the neckline to the depth of the head. This distance is then subtracted from (or added to) the neckline to reach a price target. In my experience, stocks often reverse violently after they achieve their target. This happens because a slew of technical traders all see the price target being met and close their position. Thus, you want to be aware of your target at all times and lock of your profit when the goal is achieved if you’re trading the pattern.

Now that we’ve described the pattern for you, let’s take a look at a couple of real life examples. Our first example is a head-and-shoulders top formation from one of the stocks from the Gold Space, Royal Gold (RGLD). Let’s walk through each of our qualifiers to see how this one laid out.

I. It’s very easy to see from this example that RGLD was in a strong up-trend prior to the head-and-shoulders top formation. The gold group had been on a big run as a whole during the bear market that was finalizing in this time frame. Most investors were playing the group as a hedge. Thus, when the broader market began to strengthen, it was time for the gold stocks to “pay the piper”.

II. The green semi-circle highlights the left shoulder. You can see that, at this point, the up trend looks to be in tact. The right side of the shoulder marks the first segment of the neckline

III. The blue semi-circle defines the head. Once again, the head appears to be marking a series of higher highs and higher lows. To the novice trader, this simply looks to be a sustained up-trend. Now that the head has been formed we have a trend line in place that eventually become the pivotal neckline.

IV. The red semi-circle highlights the right shoulder. At this point, the astute trader is beginning to see that the up trend is no longer in place and that something else may be in the works.

V. The neckline is now defined. The right side of the left shoulder, the right side of the head and the right side of the right shoulder have set the neckline in stone.

VI. The volume lines up perfectly on this one. We saw strong volume to the upside on the first shoulder and the head. This was the exhaustive type volume we crave for this particular formation. The volume that pushed RGLD up on the right shoulder was average at best. This was a tell-tail sign the stock was breaking down.

VII. As you can see from the chart, volume increased exponentially when RGLD broke its neckline. Typically, we want to see at least double the average daily volume break you through the neckline and it certainly did on this one.

VIII. RGLD didn’t give investors a second chance via a retest. But, we’ll see a good example of a retest in our next example.

IX. The price target for RGLD measures as the depth from the head to the neckline. You can see it on the chart marked by the blue lines. In this case, the formation measured about $5 ($29-$24). It wasn’t a coincidence that RGLD fell immediately to $19 before finding congestion.

OK, now that you’ve seen what happens when good stocks go bad, let’s take a look at a bullish example. Our next chart is for Harley Davidson (HDI). The stock had been in a severe downtrend but an inverted head-and-shoulders pattern reversed the bearish sentiment and sent HDI for a ride.

I. Once again, it’s not too hard to see that HDI was in a pretty steep downtrend. The stock had fallen roughly 35% in about four months and it looked at the time like all hope was lost for HDI shareholders.

II. The green semi-circle highlights the left shoulder. You can see that, at this point, the downtrend still looks to be in force. HDI had just set a fresh low with no base of support in place. The right side of the shoulder marks the first segment of the neckline

III. The blue semi-circle defines the head. Once again, the head appears to be marking a series of lower highs and lower lows. To the novice trader, this simply looks to be a sustained downtrend, as HDI had not successfully held any previous support area for almost four months. Now that the head has been formed we have a trend line in place that eventually become the pivotal neckline.

IV. The red semi-circle highlights the right shoulder. At this point, the astute trader is beginning to see that the downtrend may be coming to a close. This particular pullback (the right shoulder) actually stopped short of setting a new low. By definition, the downtrend has been halted, at least temporarily.

V. The neckline is now defined. The right side of the left shoulder, the right side of the head and the right side of the right shoulder have set the neckline in stone.

VI. The volume lines up perfectly on this one as well. We saw strong volume to the downside that began the left shoulder and heavy volume on the left side of the head. This was the exhaustive type volume we crave for this particular formation. This type of volume is simply washing away the “last gasp” traders that simply can’t take the downtrend anymore.

VII. As you can see from the chart, volume increased exponentially when HDI broke its neckline. Typically, we want to see at least double the average daily volume break you through the neckline and HDI gave us that and more.

VIII. This is a real good example of how previous resistance (the neckline) becomes support. HDI broke out of the inverted pattern and ran to $45 very quickly before pulling back and retesting the neckline. From there it found support and then began its push toward its measuring implication.

IX. The price target for HDI measures as the depth from the head to the neckline. You can see it on the chart marked by the blue lines. In this case, the formation measured about $6 ($34-$40). It wasn’t a coincidence that HDI reached $47.50 after breaking the neckline on its inverted head-and-shoulders pattern. As well, notice the HDI didn’t stay at $47.50 very long. It hit the measuring implication intra-day and immediately sold off. Disciplined traders knew where their profit mark was and they took their chips off the table immediately after HDI hit its target.

Occasionally, a head and shoulders formation unfolds but prices either fail to penetrate the neckline or do so only momentarily. When this happens the previous main trend resumes, usually in an explosive manner. However, the market structure at this point is invariably weak and the trend continuation, though energetic at the outset, is usually short lived. A short time later, as the pattern finally wins out, the trend terminates and reverses as was initially expected. Volume studies are of little help in recognizing the potential for a failed head and shoulder formation.

The head and shoulders pattern is one of the most dependable reversal formations you’ll find in the capital markets. It is important to remember that it occurs at market extremes and usually marks a major trend reversal when complete. The formation is one of my favorites to trade because of its constancy but also because of the measuring implications. The fact that you have a set target and clearly defined exit point makes it a trade that won’t tie up your capital for extended periods of time and gives you a reliable exit strategy. What more could a trader ask for.