distribution would appear on a chart, you saw aHead-and-Shoulders Top Formation. This is one of the more common and, byall odds, the most reliable of the Major Reversal Patterns. Probably you haveheard it mentioned, for there are many traders who are familiar with its name,but not so many who really know it and can distinguish it from somewhatsimilar price developments which do not portend a real Reversal of Trend.The typical or, if you will, the ideal Head-and-Shoulders Top is illustrated in Diagram 2. You can easily see how it got its name. It consists of:A. A strong rally, climaxing a more or less extensive advance, on whichtrading volume becomes very heavy, followed by a Minor Recessionon which volume runs considerably less than it did during the daysof rise and at the Top. This is the “left shoulder.”B. Another high-volume advance which reaches a higher level than thetop of the left shoulder, and then another reaction on less volumewhich takes prices down to somewhere near the bottom level of thepreceding recession, somewhat lower perhaps or somewhat higher,but, in any case, below the top of the left shoulder. This is the “Head.”C. A third rally, but this time on decidedly less volume than accompanied the formation of either the left shoulder or the head, which failsto reach the height of the head before another decline sets in. This isthe “right shoulder.”D. Finally, decline of prices in this third recession down through a line(the “neckline”) drawn across the Bottoms of the reactions betweenthe left shoulder and head, and the head and right shoulder, respectively, and a close below that line by an amount approximately equivalent to 3% of the stock’s market price. This is the “confirmation” or“breakout.”Note that each and every item cited in A, B, C, and D is essential to avalid Head-and-Shoulders Top Formation. The lack of any one of them castsin doubt the forecasting value of the pattern. In naming them, we have leftthe way clear for the many variations that occur (for no two Head-andShoulders are exactly alike) and have included only the features which mustbe present if we are to depend upon the pattern as signaling an importantReversal of Trend. Let us examine them in greater detail.
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B
A
C
NECKLINED
VOLUME
DIAGRAM 2. A hypothetical daily stock chart — price in the upper part andvolume at bottom — drawn to show how an ideal Head-and-Shoulders Top ReversalFormation would develop. A, B, C, and D refer to essential features listed on theprevious page.
Volume Is ImportantFirst, the matter of volume. It is always to be watched as a vital part of thetotal picture. The chart of trading activity makes a pattern just as does thechart of price ranges. The two go together and each must conform to therequirements of the case. But note also that volume is relative. When wespeak of high volume, we mean a rate of trading notably greater than hasbeen customary in that particular stock during that particular period underexamination. The exact number of shares traded is not important, nor willit ordinarily signify anything for our purposes to compare a daily volumeof, say, 6500 shares in Radio Corporation with 500 in Bohn Aluminum and
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61
3836
HUMANA INCORPORATED
HUM
1988
34323028
HSS
2624
NL
2220Sales100’S4000320024001600800
MARCHAPRILMAYJUNEJULYAUGUST SEPTEMBER27 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 2 9 16 23 30 6 13 20 27 3 10 17XD.20XD.23
FIGURE 10. Starting in March, “HUM” formed a broad Head-and-Shoulders Toppattern on the daily chart. August’s decline penetrated the neckline by 3%, confirming the Reversal Pattern. The minimum objective for the Head-and-Shoulders Topwould be 18.
Brass. The former may be very low and the latter very high as judged bythe proper technical criterion which is, in each case, the average recentactivity in the same issue. In the case of a Head-and-Shoulders Top, we havesaid that high volume attends the making of the left shoulder; so, this meansthat activity on the rise to and at the Top of the left shoulder should begreater than on the preceding rally waves in the same issue, then a MinorRecession on dwindling activity, and then a new advance on high volume.The action thus far does not differ from what we should expect of normalwave development within a continuing uptrend. In these respects, any twotypical, successively higher waves in an advance may, as you can see, becomethe left shoulder and head, respectively, of a Head-and-Shoulders Reversal.The first suggestion that a Head-and-Shoulders is really developing maycome when the volume record shows that activity accompanying the mostrecent Top was somewhat less than on the one preceding it. If this volumedisparity is conspicuous, and if it becomes evident from the way prices arereceding that the second and higher rally has ended, then the chart shouldbe tabbed with a “red” signal and further developments closely scrutinized.But such a preliminary warning does not always appear, nor should it betaken as conclusive when it does appear. Roughly estimated, about one third
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of all confirmed Head-and-Shoulders Formations show more volume on theleft shoulder than on the head, another third show about equal volume, andthe final third show greater volume on the head than on the left shoulder.Another warning — or, more often, the first — comes when prices dropin the course of the second reaction (i.e., from the head) below the level ofthe Top of the left shoulder. Such action, as we shall see later on in ourspecific study of Support and Resistance levels, is significant of weakness inthe price structure. So far it is Minor; it may be only temporary; it is certainlynot conclusive. Nevertheless, when this occurs, put a double red tab on yourchart.
Breaking the NecklineThe real tip-off appears when activity fails to pick up appreciably on thethird rally, the right shoulder. If the market remains dull as prices recover(at which stage you can draw a tentative “neckline” on your chart) and if,as they approach the approximate level of the left shoulder Top and beginto round over, volume is still relatively small, your Head-and-Shoulders Topis at least 75% completed. Although the specific application of these patternstudies in trading tactics is the province of the second part of this book, wemay note here that many stock traders sell or switch just as soon as they aresure a low-volume right shoulder has been completed, without waiting for thefinal confirmation which we named under D as the breaking of the neckline.Nevertheless, the Head-and-Shoulders is not complete, and an important Reversal of Trend is not conclusively signaled until the neckline hasbeen penetrated downside by a decisive margin. Until the neckline is broken,a certain percentage of Head-and-Shoulders developments, perhaps 20%,are “saved”; i.e., prices go no lower, but simply flounder around listlesslyfor a period of time in the general range of the right shoulder, eventuallyfirm up, and renew their advance.Finally, it must be said that, in rare cases, a Head-and-Shoulders Top isconfirmed by a decisive neckline penetration and still prices do not go downmuch farther. “False moves” such as this are the most difficult phenomenawith which the technical analyst has to cope. Fortunately, in the case of theHead-and-Shoulders, they are extremely rare. The odds are so overwhelmingly in favor of the downtrend continuing once a Head-and-Shoulders hasbeen confirmed that it pays to believe the evidence of the chart no matterhow much it may appear to be out of accord with the prevailing news ormarket psychology.There is one thing that can be said and is worth noting about Head-andShoulders Formations that fail completion or produce false confirmations.Such developments almost never occur in the early stages of a PrimaryAdvance. A Head-and-Shoulders that does not “work” is a warning that,even though there is still some life in the situation, a genuine turn is near.The next time something in the nature of a Reversal Pattern begins to appearon the charts it is apt to be final.
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63
H
38
CHI., MIL., ST. P. & PAC.
S
3634
Important Reversal Patterns
ST
1946
SG
G
NL
32302826
Sales100’s25020015010050
S
H
S
FEBRUARYMAYJANUARYMARCHAPRIL5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1
JUNE8 15 22 29
FIGURE 11. Daily chart of Chicago, Milwaukee, St. Paul & Pacific common fromJanuary 1 to June 29, 1946. Head-and-Shoulders which topped this issue’s PrimaryAdvance in February was unmistakable despite small size of shoulders (S S). Notevolume pattern. Measuring implication (see following pages) of this formation wascarried out by April. Rectangular price congestion of March 30 to May 4 is a subjectof Chapter 9. “ST” fell to 11½ in October.
Variations in Head-and-Shoulders TopsThere is a tendency, surprising when one thinks of all the vagaries of newsand crosscurrents which may influence day-to-day trading, for Head-andShoulders Patterns to develop a high degree of symmetry. The neckline tendsto be horizontal and the right shoulder tends to resemble the left in priceconfirmation (although not, of course, in volume); there is a sort of satisfyingbalance to the overall picture. But symmetry is not essential to a significantHead-and-Shoulders development. The neckline may slope up (from left toright) or down. The only qualification on an up-sloping neckline is that theBottom of the recession between the head and right shoulder must formappreciably below the general level of the Top of the left shoulder. It issometimes said that a down-sloping neckline indicates an unusually weaksituation. This is so obvious that it is apt to be given even more weight thanit deserves. A share of that excessive weakness, it should be noted, will havealready been discharged by the time the down-sloping pattern is formedand prices have broken the neckline. The measuring formula which we shalldiscuss later applies to such situations.Because of the tendency toward symmetry in shoulder development,some traders, as soon as the neckline has formed, will draw on their charts
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4440
S
H
38
3432
WX
G
NL
36
WESTINGHOUSE ELECTRIC
S
S?1945–1946
S?H?
30Sales100’s25020015010050
S
H
S
MARCHAPRILMAYJANUARY FEBRUARYDECEMBER1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25
FIGURE 12. Bull Market Top of Westinghouse Electric in 1946 was the “wideswinging,” powerful type of Head-and-Shoulders (S-H-S). Decline that broke neckline (NL)on February 13 produced a Breakaway Gap (G) discussed in Chapter 12. Measuringformula (see following pages) called for initial decline to 33. The possible BottomHead-and- Shoulders pattern (S?-H?-S?) formed in March was never completed (seeChapter 7). Note failure of prices to push up through neckline of latter at any time,despite several rally efforts in late spring while general market Averages were actually reaching new high levels. By the following November, “WX” had broken ondown to 21½. Study in detail the change in volume pattern after the end of January.
a line parallel to the neckline, extending from the top of the left shoulderthrough the head and on to the right. This furnishes a guide as to theapproximate height that the right shoulder rally should attain and, consequently, a selling level. But you will not see very many formations as perfectand symmetrical as our ideal picture, a fact which the several actual examples accompanying this chapter amply illustrate. Either shoulder may, infact, go higher or take more time than the other. Either or both may comeup nearly to the level of the head (but not equal it, else no Head-and-Shoulders) or both may fall considerably short of it. If activity attending the rightshoulder is abnormally dull, that shoulder is apt to be low but protracted intime. In general, there seems to be a balanced relation between the threeelements of price pattern, time, and volume which is practically impossibleto express in words or figures, but which one comes with experience to sensein its development. However, there are no “laws” beyond those stated in ourA, B, C, and D; within those limits, look for an infinity of minor variations.
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Important Reversal Patterns
65
HS
S
256240224
TELEDYNE INC.
TDY
1984
208192176160Sales100’s200016001200800400JUNEJULYAUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29
FIGURE 13. A large Head-and-Shoulders Topping Pattern evolved in “TDY” over5 months, with December’s high-volume plunge through the neckline confirmingthe Trend Reversal. Since this was a very expensive stock, you might have consideredbuying the April 260 puts instead of selling “TDY” shares outright. Our measuredobjective in this issue was 44 points from penetration of the 264 neckline, or 220.
Price Action Following Confirmation:The Measuring FormulaThe final step, the downside penetration of the neckline, may be attendedby some increase in activity, but usually isn’t at first. If volume remains smallfor a few days as prices drift lower, a “Pullback” move frequently ensueswhich brings quotations up again to the neckline level (rarely through it).Normally, this is the “last gasp”; prices then turn down quickly, as a rule,and break away on a sharply augmented turnover. Whether or not a PullbackRally will occur after the initial penetration seems often to depend on thecondition of the market in general. If the whole market trend is turning downat the same time as our individual issue, which has just completed itsHead-and-Shoulders, there will probably be no Pullback; prices instead willtend to accelerate their decline, with activity increasing as they leave thevicinity of the Top. If, on the other hand, the general market is still firm,then an attempt at a Pullback is likely. Also, the odds seem slightly to favora Pullback if the neckline has been broken before much of a right shoulder
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32
60
30
56
28 S
52
26
48
24
H
I C INDUSTRIES
ICX
1986
S
NL
12414
10356
22
Sales100’s1000800600400200
JUNEJULYAUGUSTSEPTEMBER OCTOBER NOVEMBERDECEMBER14 21 28 5 12 19 26 2 9 16 23 30 6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27XD.20XD.20XD.40 2/1SPLIT
FIGURE 14. “ICX” was in a powerful uptrend for over a decade and gains werespectacular. But the upward momentum began to fade and Topping indications wereevident. The August peak fulfilled the objective of the measuring Flag formed during1985. The August gap to new highs was quickly filled, indicating that it was anExhaustion Gap. The reaction back to Support, followed by a slow, relatively lowvolume rally to the July high, formed a credible right shoulder. The final week’s highvolume plunge through the neckline confirmed the Reversal. The minimum objectivefor the Head-and-Shoulders Pattern was 19¼, the top of the 1985 Flag. A possiblealternative cover point was the Bottom of the Flag at 14¼.
developed, but certainly no very sure rules can be laid down. In any event,the Pullback Rally is of practical interest chiefly to the trader who wants tosell the stock short, or who has sold it short and has then to decide wherehe should place a stop-loss order.Now we come to one of the most interesting features of this basic Reversal Formation — the indication which it gives as to the extent (in points) ofthe move which is likely to follow the completion of a Head-and-Shoulders.Measure the number of points down vertically from the Top of the head tothe neckline as drawn on the chart. Then measure the same distance downfrom the neckline at the point where prices finally penetrated it followingthe completion of the right shoulder. The price level thus marked is theminimum probable objective of the decline.
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208DU PONT192
S
H
DD
S
176160152
1936–1937
144Sales100’s5040302010
S
H
S
OCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20 27 6 13 20 27
FIGURE 15. Reversal Formations, which develop in important stocks while thegeneral market is still apparently in a strong trend, are often difficult to believe, muchless act upon. But they may be highly significant. DuPont topped out in 1936,4 months ahead of the Averages. Despite its extended right shoulder (but note volume), Reversal implications were clear on December 19. The Pullback of January,meeting supply at the old neckline level, and the second try in March were interestingand typical of such a general market situation. Compare with Figure 12.
Let us hasten to state one important qualification to the Head-andShoulders Measuring Formula. Refer back to our original set of specificationsfor a Head-and-Shoulders. Under A, we required “strong rally climaxing amore or less extensive advance.” If the up-move preceding the formation ofa Reversal Area has been small, the down-move following it may, in factprobably will, be equally small. In brief, a Reversal Pattern has to havesomething to reverse. So, we really have two minimums, one being the extentof the advance preceding the formation of the Head-and-Shoulders and theother that derived by our measuring formula; whichever is the smaller willapply. The measuring rule is indicated on several of the examples thatillustrate this chapter. You can see now why a down-sloping neckline indicates a “weaker” situation than an up-sloping, and just how much weaker,as well as the fact that more than half of the minimum expected weaknesshas already been expended in the decline from the Top of the head to thepenetration of the neckline.The maximum indications are quite another matter, for which no simplerules can be laid down. Factors that enter into this are the extent of the
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HS
S
48
NL
CONSOLIDATED EDISON
ED
444038
1937
363432Sales100’s5040302010
HS
2
S
JANUARYFEBRUARYMARCHAPRIL9 16 23 30 6 13 20 27 6 13 20 27 3 10 17 24 1
MAYJUNE8 15 22 29 5 12 19 26
FIGURE 16. Another 1937 Bull Market Top of Head-and-Shoulders Form, with onlyone quick Pullback (February 10). In this case, volume increased sharply on February5 with the initial break through the neckline (NL). Measuring formula was satisfiedin March. Study this picture in connection with “ED’s” long-range chart (Figure 89)in Chapter 10, and turn back to it later when you come to the Support-Resistancestudy in Chapter 13.
previous rise, the size, volume, and duration of the Head-and-ShouldersFormation, the general market Primary Trend (very important), and thedistance that prices can fall before they come to an established Support Zone.Some of these are topics for later discussion.
Relation of Head-and-Shoulders to Dow TheoryWithout doubt, some readers have already suspected that the Head-andShoulders Pattern is, in a sense, just an adaptation of the principles of DowTheory to the action of an individual stock. So it is. The decline of pricesfrom the head to the neckline, the rally to the right shoulder, and then theensuing decline that breaks the neckline set up a sequence of lower Topsand Bottoms analogous to those which signal a downtrend in Dow Theory.This logical relation of the Head-and-Shoulders to Dow Theory is anotherreason, in addition to its basic importance, frequency, and dependability,why we have placed it first in our study of Reversal Formations. But it is
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H24
S20191817
REPUBLIC
AVIATION
RA
1946
16Sales100’s25020015010050
S
H
MEASUREMENT
22
MEASUREMENT
S
S
APRILMAYJUNEJULYFEBRUARY MARCH2 9 16 23 2 9 16 23 6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3
FIGURE 17. The 6-month-long Head-and-Shoulders Top of Republic Aviation in1946. Such a pattern became a possibility to be watched for when prices broke downin May below the level of the February high (first S). Refer to requirement B. Notealso how the Head-and-Shoulders Measuring Formula (Chapter 7) is applied to patternswith up-slanting necklines. Minimum downside requirement here was 12½, reachedin November. The quick Pullback on July 27 gave a last good selling opportunity.
more definite, gives advance warnings which are relatively easier to detect,and is quicker with its signals in the case of up-sloping necklines. Also, itrequires no specified minimum time for any of its component moves, andno confirmation by another stock or Average.There are Head-and-Shoulders Bottoms (EN: An undescriptive term for abottom formation which I would prefer to call the “Kilroy Bottom.” See Figure 23.1)as well as Tops, with equally important implications. The Bottom Formationswill be taken up in our next chapter.
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H
DISNEY WALT PRODUCTION
5652
DIS
1986
S
S
4844
20787
1.1260
1906619244201021805617473
NL
Sales100’s200016001200800400
AUGUSTSEPTEMBER OCTOBERMAYJUNEJULYMARCH APRIL15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20 27 4 11XD. 08XD. 08
FIGURE 18. After a sharp reaction from its 1983 high, which lasted a year andpushed “DIS” back to long-term Support, the Bulls took over and sent Walt andfriends on a trip to the moon. But beginning in April, the rocket began to lose power,and it looked like reentry had begun. Since the big-volume days of spring, this issueetched out a large Head-and-Shoulders Top. High-volume penetration of the necklineby 3% confirmed the Reversal.
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71
H32S
S
30
NL
28262422
IU
T
NEW YORK CENTRAL
CN
1945
Sales100’s500400300200100APRILMAY7 14 21 28 5 12 19 26 2
JUNE9 16 23 30 7
JULYAUGUST14 21 28 4 11 18 25 1
SEPTEMBER8 15 25 29
FIGURE 19. New York Central made a Head-and-Shoulders Top in June 1945.Intermediate Up Trendline (IUT) was broken by drop from head on July 5. Minimummeasuring implication was carried out at 24 on August 18. Reaction ended a fewdays later at 22¾. Prices recovered to projected neckline (see September 25), droppedagain to 26⅞ in October, and then pushed up, giving “rebuy” signal (on Fan Lineconstruction) at 30 in first week of November. Final Bull Market High was made inJanuary at 35½. The period from August 1945 to February 1946 was difficult fortechnical traders in this stock. Those who sold at 26–27 in July 1945 could, however,congratulate themselves in May 1947 when “CN” hit 12.
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S
136128
HSS
S
12011210496UNION CARBIDE & CARBON
UK
888076
1929
726864Sales100’s125100755025NOVEMBER DECEMBERJULYAUGUSTSEPTEMBER OCTOBER6 13 20 27 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28
FIGURE 20. The great 1929 Bull Market Top was characterized by many impressiveHead-and-Shoulders Formations, of which this is an interesting example. Note thesmall Head-and-Shoulders Pattern of September, which became the head of a muchlarger formation of the same character. The Pullback of October 9 to the upperneckline afforded a second chance to get out at 128 to those who did not sell immediately when this first line was decisively penetrated on September 28. The largerpattern “broke” on October 19, with a quick pullback on October 22. Less than amonth later “UUK” had lost half its peak value. By 1932 it had fallen to 15½. Althoughsuch a catastrophic decline as 1929–32 may never come again, the moral is, nonetheless, plain: Never scorn a Head-and-Shoulders Formation. Patterns such as this mergeinto the “multiple” types discussed in Chapter 7. Although this example is selectedfrom the 1929 portfolio, they were not at all uncommon mid-20th century. Severalmodern examples appear in our later pages.
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$SPX .X(D) -Weekly CBOEL =1130.65 –11 .40 –1 .00%
73
Complex Head
C=1130.651455 .001332 .00
Shoulder
Shoulder
1220 .001130 .001023 .00
943 .94
937 .00
Neckline
858 .00786 .00720 .00659 .00
1997
1998
1999
2000
2001
2002
20032004Created with TradeStation
FIGURE 20.1. A massive Head-and-Shoulders in the S&