dealing with a formation that has a lifetime(width) of 1 day, I do not think the trend need be a large one. As long as priceshave been rising noticeably, that is good enough for me.Figure 17.1 shows what I am talking about; there are a number of hanging man formations highlighted. Each daily price move in the chart shows as ahigh-low-close figure; the opening price is not shown. Those prices highlighted by the black circles have the opening price at the daily high—a truehanging man formation.
255
The price trend, having spurted from a low of 1.88, forms a rising trend.That is a key element in the formation; the reversal needs something toreverse. Point A, however, shows that the price trend leading to it is downward.Others, like point B, suggest the beginning of an uptrend (albeit, 2 days later).Point C is a hanging man formation that just marks time. This is probably themost common. Point D, arguably, is a successful hanging man reversal. Prices
rise for 3 days then move flat. It is a change in trend, from a rising trend to ahorizontal one or consolidation. The move from point D to B is downward,further suggesting a true reversal of the upward trend (although stretched outsomewhat).Of course, my favorite is the August reversal. Unfortunately, as you cansee by the many black dots, the formation rarely works as expected even during a rising price trend.
Focus on Failures
In early August, for example, you can see that a hanging man formationsurfaces a day after prices peak at 3. The open (not shown), high, and close are
all at the same value, 3. The daily low, at 2.81, is more than 5% below the dailyhigh (it is significantly lower by 6.3%). The prices leading die way up either do
not have the open at the daily high or do not have an intraday low 5% belowthe high. They are not hanging man formations (since the chart does not showopening prices, you will just have to trust me).
Figure 17.2 shows two types of hanging man failures. The first one, on the left,I use to illustrate the belief that a hanging man formation should show a higherhigh the next day. In this example, it does not. Prices continue their downwardtrend. A higher high happens only 44% to 57% of the time, depending onwhether you include the opening price in the formation or not, respectively.
The Statistics section further describes this behavior.Roberts Pharmaceutical (Drug, ASE, RPC)
Sep
Figure 17.1 A true hanging man formation. The black dots mark the hangingman formations. While only the high, low, and closing prices show in the graph, theblack dots mark the days in which the opening price also matches the intraday high.
Oct
Figure 17.2 Two types of hanging man failures. A higher high is expected theday after a hanging man formation, or it should result in a reversal of the upwardprice trend.
256
Hanging Man
Statistics
The right formation failure illustrates a failure of the price trend toreverse. You can see that the hanging man formation has a high of 2 !3/4 but 2days later the high reaches 26'/2. This performance is hardly what I would calla reversal of the upward price trend. In this example, the formation acts as acontinuation of the short-term uptrend.Failures of the second type, where a price reversal is predicted but doesnot appear, happen 67% of the time. To flip this around, it is more accurate tosay that prices will continue moving upward two-thirds of the time. With sucha poor showing, I can only infer that the hanging man formation does notapply to stocks. Maybe it works better with other security types.With such an astronomical failure rate, I rechecked my work. In a fewformations, the hanging man pattern appears a few days before a peak (such as
that shown in Figure 17.2). Most of the time the hanging man appears in themiddle or near the beginning of an uptrend. Prices simply do not reverse afterthe formation—they continue moving higher.There is one simple thing you can do to drop the failure rate to zero. Simply do not trade this one (or rely on it).
StatisticsTable 17.2 shows the first batch of statistics. Since many of the descriptionsabout a hanging man formation say the opening or closing price should be nearthe intraday high, I provided a range of distances to work from. The closing
257
same as the intraday high price with a significantly lower low (but a risingprice trend is not a requirement).
The statistics in Table 17.2 show how often the daily high price risesabove the T-bar or hanging man formation the following day. In the T-bar
column, the number of samples is huge—the smallest sample size is over78,000. Of course, that is on 500 stocks over a 5-year period of daily price data(2,500 years). When the closing price is at the intraday high, a higher high
occurs the next day 55.4% of the time. Even when the closing price driftslower, the percentage remains nearly the same with a best case of 57.2%. Thisis only slightly better than a fair coin toss (50%) and probably allows for thehistorical upward trend in the markets over time.I evaluated the hanging man column on those formations where both theopening and closing prices are near the intraday high. In the case of 0%, theopen and close match the daily high. Only 44.4% of the time is a higher highmade the next day. Performance improves after allowing the open and close todrift downward. Almost half (48%) the formations have higher highs the next
day. Incidentally, the minimum sample size is still a massive 27,600 plus.I created Table 17.2 to specifically test the theory that a closing price nearthe daily high suggests a higher high the next day. From the results shown indie table, I consider the theory to be unreliable—certainly nowhere near thepredicted 80% success rate. A close near the intraday high is no guarantee of ahigher high tomorrow, as far as common stocks are concerned.
Table 17.3 shows general performance statistics for the hanging man for-
A T-bar formation is one that looks like a hanging man except the opening
mation. The price trend leading to the formation is generally ignored whenexamining the formation (except for failure rates discussed in a moment). I separated the chart pattern into two types: upside and downside breakouts. Withover 56,000 hanging man formations in 2,500 years' worth of daily price data,
price is disregarded. In the hanging man formation, the opening price is the
I had to make some changes to drop the sample size to a reasonable amount.
price ranges from 0% to 25% below the intraday high.
Table 17.2 provides two types of formations, a T-bar and a hanging man.
I used the same procedure for the hanging man formation as I have for
other chart patterns (such as inside and outside days). For those stocks thatTable 17.2Statistics Showing Number of Times the Daily High Price Rises above T-Bar orHanging Man Formation the Following DayClosing Price BelowIntraday High
T-Bar
Hanging Man
0
55.4
10
56.457.057.2
44.444.745.447.048.0
15
2025
56.6
Note: A T-bar formation is a hanging man with the opening price ignored. A hanging manallows the opening and closing prices to drift lower but has a significantly lower intraday low.
have more than 10 formations, I ration the number I accept. If a stock has 100
formations, for example, I accept 1 in every 10 so that 10 formations remain,sprinkled throughout the 5 years of daily price data. You can see in the tablethat these are about evenly split (by chance) between upside breakouts (274)and downside breakouts (261). Those formations with upside breakouts arepredominantly reversals of the short-term price trend, whereas those withdownside breakouts act as consolidations of the trend.The failure rate, at 67%, is the worst I have seen for any formation. Inorder for the formation to qualify as a failure, it must first be a hanging man
chart pattern passing these three criteria:1. Intraday open, high, and close are all the same value
2. Intraday low is at least 5% below the high3. Occurs during a short-term (or longer) rising price trend
258
Hanging Man
V
Table 17.3General Statistics for the Hanging Man FormationDescription
Upside Breakout
Downside Breakout
Number of formations in 400 stocksfrom 1991 to 1996, limited to about10 formations per stock
274
261
104 consolidations,170 reversals
210 consolidations,51 reversals
Reversal or consolidation
outs, this happens 11 % of the time, wherethe failure rate (22%). I consider anythingTo assess the average rise or decline oman formations, I looked at the breakout dmations that fail. The remaining formatibreakouts and losses averaging 16% for do
Shown in Figures 17.3 and 17.4 are f
losses, respectively. For upside breakouts, dYou can see in Figure 17.3 that 15% of thand a third of the formations have gains oaverage upward.Figure 17.4 shows the results for doscale is in 5% increments and the tallest co
Failure rate (good formation: anupward trend reversal)
104/155 or 6 7%
N/A
5% failure rate
29 or 11 %
58 or 22%
Average rise/decline for successfulformations
40%
16%
Most likely rise/decline
10%
5% to 10%
For successful formations, days toultimate high/low
2.5 months (78 days)
1.5 months (41 days)
Percentage occurring near12-month low (L), center (C),or high (H)
L66%, C17%, HI 7%
L77%, C1 6%, H6%
Percentage gain/loss for each12-month lookback period
time, 41 days. Both numbers, in comparupside breakouts about twice as long to go
L41%, C26%, H53%
LI 5%, C12%, H17%
Volume day before to day afterversus 25-day moving average
107%, 115%, 102%
107%, 115%, 102%
I determine the ultimate high or lowadverse move of at least 20%. Finding thefor example, means prices rise then declin
Percentage gain/loss for volume1.5x 25-day moving average
28%
16%
Percentage gain/loss for volumeO.Sx 25-day moving average
45%
15%
Number of high volume failures(1.5x 25-day moving average)
19 or 18%
N/A
Number of low volume failures(O.Sx 25-day moving average)
42 or 40%
N/A
the 5% column is quite close, I consider th
and 10%.
Successful formations with upside bultimate high. Downside breakouts reach
On occasion, the 20% figure is excessive, a
After meeting the three conditions (it is just a hanging man formation ina rising price trend), I examine the following days to see if the trend reverses(in other words, a downside breakout). Most of the time (67%) prices keep rising. There is no corresponding failure rate for downside breakouts because, bydefinition, a hanging man formation that works has a downward breakout
(prices move lower the next day). There are only 155 formations (of the stocksI examined) that meet the three criteria just described and of these, 104 haveupside breakouts (the breakouts should be down, so they are failures).Since such a high failure rate is suspicious, at least in my mind, I lookedat all hanging man formations with the 5% failure rate in mind. A 5% failureis when prices break out in a given direction and move less than 5% beforereversing and moving significantly in the other direction. For upside break-
40
50
Percentage G
Figure 17.3 Frequency distribution of gainupside breakouts. The most likely gain is 10%
260
Hanging Man
Trading Tactics
261
the 25-day moving average, 40% of the formations fail. Only 18% fail withhigh volume. These numbers suggest that you should be watchful of a hangingman formation in a price uptrend that shows below average volume. It maycontinue moving up instead of reversing.
Trading TacticsAfter careful consideration, I cannot recommend trading this formation. Theprimary belief behind this chart pattern is that prices will reverse the uptrend.They do not. Just a third of the formations reverse, whereas the others see
prices continue higher.The only advice I can offer is when you are considering buying or sellinga stock and see a hanging man formation. It is probably best if the openingprice is well below the intraday high but the stock closes at the high, suggest20
25
30
Percentage Loss
Figure 17.4 Frequency distribution of losses for hanging man formations withdownside breakouts. The most likely loss is between 5% and 10%.
same methodology applies to downside breakouts. Such a large swing accommodates normal price behavior and quickly identifies significant trend changes.Does a hanging man formation occur near the yearly high or low? Bothupside and downside breakouts occur most frequently within a third of theyearly low. When you overlay performance on the yearly price range, the bestperforming upside breakouts are those occurring within a third of the yearly
high, scoring average gains of 53%. Downside breakouts are more evenly splitbut the highest return made by those formations appears within a third of theyearly high (with an average 17% loss).
The volume during a hanging man formation is higher than average. Youcan see in Table 17.3 that the formation itself has a volume trend that is 15%above normal (115% of the 25-day moving average). Both the day before andthe day after the formation show high volume.Do hanging man formations with high volume produce superior results?No. When volume is 50% (1.5x in the table) or more above average, the average gain is only 28%, well below the 40% scored for upside breakouts. However, when the volume is 50% below average, the performance improvesdramatically: 45%. For downside breakouts, the performance hovers aroundthe 16% average gain.Does volume relate to the failure rate? To answer this question, I separated the formations with upside breakouts into three categories: volume thatis 50% above average, 50% below average, and everything else. The majorityof the failures occur between the two 50% ranges. When volume is 50% below
ing upward momentum. The following day, there is a very slight tendency topost a higher high. So, if you are selling, you might wait for the new high or atleast follow the stock closely throughout the day.If you are buying just before the close and the price is at or near the intraday high (again, with the opening price near the intraday low), you might take
comfort in believing tomorrow's price will be higher—at least sometime during the day. The odds suggest a higher price, but the odds are not much betterthan a coin toss, certainly not worth betting the farm on.
18
The Results Snapshot highlights statithe top version of the formation, the bottomrate of 5%. Only a few formations either fa
that do experience an upside breakout cont
Head-and-ShouldersBottoms
Like many bullish formations, the heaprice target often: 83 % of the time. I consid
Tour
What does the formation look like? Figurehead-and-shoulders bottom. The stock sta
peaks during February, where the figure b
moves downward and makes a lower low inturn marks the left shoulder. The stock dec
during late April, forming the head. The rrecovers then continues moving down alon
18.1 as the neckline).The stock advances above the necklin
However, the rise does not last long. Prices
right shoulder. The stock moves sidewaysRESULTS SNAPSHOTAppearance
Three-trough formation with center trough lowerthan the others
Reversal or consolidation
Short-term (up to 3 months) bullish reversal
Failure rate
5%
Average rise
38%, with most likely rise between 20% and 30%
Volume trend
Downward; usually higher on the left shoulder thanthe right
Throwbacks
52%
Percentage meetingpredicted price target
83%
See also
Head-and-Shoulders Bottoms, Complex
I find it easier to pick out tops than bottoms. Perhaps this is because I spend somuch time worrying about when to sell. Placing a trade is easy but getting outis the tough part. In my quest to sell at the appropriate time, I have often overlooked the buy side: bottom reversals. Head-and-shoulders bottoms are justsuch a formation. They are quite easy to spot and can be very profitable.
262
stock enters another head-and-shouldersproves more lasting. By mid-August 1995,
Arrow Electronics Inc. (Electro
Feb94
Figure 18.1
Apr
May
A head-and-shoulders bottom
lower head. Volume is usually higher on the le
264
Head-and-Shoulders Bottoms
The head-and-shoulders bottom shown in Figure 18.1 has a somewhatunusual volume pattern. Volume is usually highest on the left shoulder, diminished on the head, and even lower on the right shoulder. The rise from thehead to the right shoulder accompanies a rise in volume as does the actualbreakout.In contrast, the formation shows little increase in volume during the rise
from the head to the right shoulder. Volume on the breakout is unexciting andthat helps explain why the stock stalls. Upward momentum fails to happenquickly enough to propel the stock higher; the stock rounds over and headsback down.
Figure 18.2 shows a head-and-shoulders formation on a weekly timescale. I chose this chart to show you the typical trend of head-and-shouldersbottom reversals. They usually form after an extended downtrend in prices. Asa reversal, once they complete, prices rise.
new low and this becomes the head. Thestock in anticipation of an eventual rise orstock moves up on receding volume then re
Volume on the three troughs is diminhigh volume, the head exhibits somewhat lrecords the lowest volume up to that point.
from the right shoulder does volume spike
Breakout volume, depending on wh
occurs, is unconvincing. In late August, pricline and stage a definitive breakout. Even svolume advances noticeably.
Identification Guidelines
Why do head-and-shoulders bottoms form? The formation represents a
struggle to find the bottom, the lowest price that represents the best value. Asthe stock descends during February 1994, investors nibble at the stock inincreasing numbers. Volume climbs even as the stock descends until it spikesupward for 1 week during formation of the left shoulder. Buying demand putsa crimp on the downward slide and prices move up but only for a week. Thefollowing week, prices move lower. Again, volume spikes as the stock makes a
Table 18.1 encapsulates the identification gbottom. Consider Figure 18.3, a head-anddoes not appear at the end of a long-term
(up to 3 months). The uptrend begins the pshoulders bottom. The formation reversesbut continues the long-term uptrend.Overall, the formation sports the thrhead, and right shoulder. The left shoulder
Alien Telecom Inc. (Telecom. Equipment, NYSE, ALN)
Table 18.1Identification Characteristics of a He
A S O N D 9 5 F M A M )
I
Characteristic
Discussion
Shape
A three-trough formatioother two. It looks like adown. The three troughswell defined.
Symmetry
The left and right shouldeabout the head, somewThere are wide variationsymmetrical about the h
Volume
Usually highest on thethe right shoulder.
Neckline
A line that connects the
piercing of the necklineneckline if the slope is torise between the shoulde
A S
Figure 18.2 Head-and-shoulders bottom formation on a weekly time scale. Ittakes several months before this head-and-shoulders bottom stages an upsidebreakout. Volume is characteristic: highest on the left shoulder, diminished on thehead, and exceedingly low on the right shoulder.
Upside breakout
The breakout is upward,prices upward. A low voimpending failure.
266
Head-and-Shoulders Bottoms
"
3 Com Corp. (Computers & Peripherals, NASDAQ, COMS)-40
The neckline is an imaginary line connshoulders and the head. It can slope downwamations, the slope of the line is not very steebe a disqualifier of a head-and-shoulders b
rather steep neckline).Irregular volume patterns should also nures 18.1 and 18.3, for example, have volum
Lett Shoulder
Head
Breakout volume is usually high as itHowever, in a quarter of the formations whout volume is well below the day before theFailures section that high breakout volumerule, volume will rise on the day of the brea
Right Shoulder
Focus on FailuresFeb 95
Figure 18.3
Apr
May
jun
|ul
A rare head-and-shoulders consolidation of the primary uptrend.
Like most formations, there are two types oFigure 18.4, is a failure of the head-and-sholine and move higher. As you would expecdowntrend in prices. The highest price peakcorner of Figure 18.4. From the high of 383/4,
the right one and appears to be about the same width. Such symmetry is com-
2ll/4, a decline of 45%. When the bottom form
mon in head-and-shoulders formations (tops, bottoms, and the complex vari-
An interesting thing about the formatishoulder is almost the same shape as the r
ety). If the left shoulder is sharp or pointed, the right shoulder will be too.The head is below both shoulders by a reasonable amount. By this characteristic I mean the formation is not a triple bottom—three troughs at aboutthe same price level.In Figure 18.3, the left shoulder suddenly declines for 3 days, thenreverses and climbs to a minor high. Similarly, the rise between the head andright shoulder climbs almost to the height of the rise between the left shoulderand head then descends to the right shoulder. All five features, the threetroughs and two minor rises, appear well defined and distinct. The features areimportant as you scan your charts looking for head-and-shoulders bottoms.Symmetry is another important key to selecting a valid head-and-shoulders bottom. The right side of the formation usually mimics the left side. Theright shoulder declines to about the price level of the left shoulder and die distances of both from the head are similar. Of course, there are many variations,but symmetry should make a head-and-shoulders bottom stand out from asequence of any three depressions.Volume represents anodier clue to the validity of a bottom. The left shoulder typically has the highest volume, followed by the head, with diminished volume on the right shoulder. Thus, overall, the volume trend is downward; higheron the left side of the formation than the right—until the breakout.
Mar 94
Apr
May
|un
|ul
Aug
Figure 18.4 Failure of a head-and-shoulders b
268
Head-and-Shoulders Bottoms
V'
two shoulder lows and the head is well below both shoulder troughs. Theright shoulder is somewhat farther away from the head than the left. Thischaracteristic is typical.Volume is suspiciously low throughout the formation. The left shoulderand head register about the same level of volume. The right shoulder volume,however, is higher than the other two. Of course, an irregular volume patternis no reason to discard a formation—but it serves as a warning.After the right shoulder forms and prices begin rising, volume tapers offrapidly and the attempt to pierce the neckline fails. The rally attempt does noteven come close to the neckline.Looking at the overall formation, there is no one item that signals animpending failure. There is some suspicious activity, principally the abnormalvolume pattern, but nothing to deter an investor.Figure 18.5 shows a slightly different type of failure. This is what I call a5% failure. The two shoulders and head appear well formed and distinct. Theleft shoulder looks different from the right, but the twin rises between theshoulders are similar. The price level of the two shoulders is not suspiciouslyout of line.Volume is unusual. The only heavy volume appears near the head asprices rise away from it toward the right shoulder. The right shoulder volumelooks like something you would want to tackle with your shaver: annoying butnot high enough to be alarming.
Prices advance smartly after the righabove the stair-step incline, they zoom upwstock moves essentially sideways for 2 weekAlthough this formation does have anby more than 5% above the neckline. Pricesthreshold, but they do not. The result is a frise by more than 5% after a breakout or thI went through the various failures in tsee if there is any truth to the notion that lofailure. I found that this simply is not true.8 (44%) occur after a low volume breakout(30 samples usually provides reliable resbring us to die next section: Statistics.
Statistics
Table 18.2 contains general statistics for htions. There is a good assortment of formatiof daily price data. Most of the formations,remainder are consolidations of the prevaili(95%) perform as expected. This means thhigher by more than 5%. The average rise a
Table 18.General Statistics for Head-an
Airborne Freight (Air Transport, NYSE, ABF)'I
Description
Number of formations in 500 stocks from 1991
to 1996Reversal or consolidationFailure rate
Average rise of successful formationsMost likely rise
Of those succeeding, number meeting or exceedinprice target (measure rule)Average formation lengthNumber of successful formations showingdownward volume trendAverage rise of up-sloping neckline versus downsloping neckline
Figure 18.5 A 5% failure in a head-and-shoulders bottom. Prices must rise by atleast 5% before the formation is a success. A 5% rise should take prices to 393/s butit does not happen.
Average rise of higher right shoulder versus higherleft shoulder
Note; With a 5% failure rate and an average rise ois a formation worth considering.
270
Head-and-Shoulders Bottoms
V'
Since large numbers can skew averages, I computed a frequency distribution of the percentage gains. Figure 18.6 shows the results. The lopsidedbell-shaped curve seems to be typical for most formations and the head-andshoulders bottom is no exception. Notice the large number of gains over 90%.These tend to pull the overall average upward. The frequency distributionshows the most likely rise is between 20% and 30%, down slightly from theaverage gain of 38%.
In the Trading Tactics section of this chapter I explain the measure rule.It is a way for a formation to predict the minimum price move. For the headand-shoulders bottom, the prediction succeeds 83% of the time, a comfortingnumber (I view anything above 80% to be reliable).
The formation length from left shoulder trough to right shoulder troughis 21/: months. This understates the formation length somewhat because it doesnot include the run down to the left shoulder and the rise to the breakout. Occasionally, it can take several weeks or months before prices stage a breakout.About two-thirds (62%) of the formations show a downward volumetrend. The slope of the linear regression line between the shoulder lows measures this. The result fits with casual observation in that the left shoulder usually has the highest volume, followed by the head and greatly diminished right
shoulder volume.Does the slope of the neckline or the shoulder height predict the magnitude of the resulting rise? I looked into these questions and found results dif-
Statistics
upward (the rise on the left is below the rise on the right), the stock has an average gain of 38%, versus 40% for those stocks with down-sloping necklines.In a similar manner, I looked at the higher of the two shoulders. Does ahigher right shoulder suggest a larger gain? No. The average rise of stocks withhigher right shoulders is 36% while those with higher left shoulders gain anaverage of 41%.For both necklines and shoulder height the results are not statistically significant. This means the results could be due to chance, or there could be someveracity to the difference.Table 18.3 shows statistics related to the breakout. Nearly all (98%) ofthe head-and-shoulders bottoms have upside breakouts. There are only eightformations that have downside breakouts. Of those formations with upsidebreakouts, 10 fail to rise by more than 5%.Throwbacks, when prices break out upward then return to the neckline,occur 52% of the time. This suggests some hesitancy of the formation to rise.It takes, on average, 11 days for the stock to return to the neckline and complete a throwback. This seems to be about average for many formations inthis book.Is a formation more likely to throw back after a low volume breakout?No. I separated the formations into two columns: those that have breakoutswith high volume (over 125% of the prior day) and those with low volume (less
ferent from what I expected. For necklines in which the slope of the line is
Table 18.3Breakout Statistics for Head-and-Shoulders BottomsDescription
Figure 18.6 Frequency distribution of gains for head-and-shoulders bottoms. Themost likely rise is between 20% and 30%.
271
Statistic
Upside breakout
322 or 98%
Downside breakout
8 or 2%
Upside breakout but failure
10 or 3%
Throwbacks
167 or 52%
Average time to throwback completion
11 days
Is a formation more likely to throw back aftera low volume breakout?
No
For successful formations, days to ultimate high
7 months (215 days)
Percentage of breakouts occurring near12-month low (L), center (C), or high (H)
L29%, C41%, H30%
Percentage gain for each 12-month lookbackperiod
1.37%, C34%, H44%
Volume for breakout day and next 5 dayscompared with day before breakout
163%, 125%, 104%, 95%, 97%, 95%
Successful breakouts on high volume
1 64 or 74%
Successful breakouts on low volume
59 or 26%
Formation failures on low volume
8 or 44%
Note: The vast majority of breakouts are upside breakouts.
272
Head-and-Shoulders Bottoms
^--
than 75% of the prior day). Then I matched the throwbacks with the twocolumns. The results split evenly at 49% for each column. The results suggestthat a throwback is independent of breakout volume.After a breakout occurs, it takes about 7 months to reach the ultimate
Table 18.4Trading Tactics for Head-and-Shoulders BottomsTrading Tactic
Explanation
Measure rule
Compute the formation height by subtracting the valueof the lowest low reached in the head from the neckline, measured vertically. Add the difference to the pointwhere prices pierce the neckline. The result is the targetprice to which prices will rise, at