19 Dec 2012 Investor Education Series – Technical Analysis: Reversal Patterns – Head & Shoulders
Technical analysis patterns can be deivided into two types, reversal and continuation patterns. Reversal patterns indicate that the primary trend is likely to change direction, from an up trend to a down trend or vice versa. Continuation patterns indicate a trend is likely to continue, but the pattern gives valuable measuring objective.
Head & Shoulders (H&S):
The head and shoulders pattern is the most reliable reversal pattern and works more than 70% of the time. Being a reversal pattern, it indicates a turnaround in the major trend. It can occur at the top or bottom (inverse H&S) of a price chart.
To form a head and shoulders (H & S) pattern there must be at least five reversals of the major trend. In an up trend, the first correction (from reversal point 1) and the rally to a new high (from point two) are still compatible with a bull market (see Figure 1). The first two reversals will be known as the left shoulder. The reversal from point 3 will be known as the head. If the third reversal takes prices lower than the top of the left shoulder, support has been violated. This is the first sign of weakness in the major trend. The rally from reversal point four should occur on lower volume than the volume on any part of the previous rallies. The rally should not go to a new high, but reversal point 5 must be lower than reversal point 3 (the top of the head). The neckline is the minor trend line drawn tangent to reversal points two and four.
The trader should wait for a completion of the pattern by a close below the theoretical neckline. Then sell the share short or buy the share if an inverse Head and Shoulder pattern occur. The minimum objective can be determined by taking the distance from the top of the head (reversal point 3) to the neckline and adding that distance to the point where the neckline was broken. The trader should take profits on at least half of his position. The trader can also establish a fail-safe line where he should put a stop-loss. This line is the minor trend line drawn tangent to the top of the head and the top of the right shoulder (reversal points 3 and 5). Whenever prices move above the fail-safe line, the trader should cut all his positions.
Graph 1: H&S on Copper price.
Graph 2: Inverse H&S AECI.
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