A Head & Shoulders [H&S] pattern is major top reversal formation with specific requirements and measuring implications.

• The first portion of this article defines the pattern & its characteristics in is taken from two articles from 2010.
• The second portion provides a potential H&S pattern forming in QQQ.

Chart Patterns

The classic text, Technical Analysis of Stock Trends, by Robert D Edwards and John Magee, developed price and volume patterns in conjunction with Dow Theory concepts. The 9^th edition published in 2007 marks 60 years for the work which remains relevant today. While the pattern definitions and discussion provided here use the 7^th edition as a point of reference, testing data reflect Thomas N. Bulkowski’s work provided in the 2006 text, Technical Analysis: The Complete Resource for Financial Market Technicians, by Charles D, Kirkpatrick, CMT and Julie R. Dahlquist, PhD. For those interested, note that Mr. Bulkowski’s work is also available in his 2006 text, Encyclopedia of Chart Patterns.

The Head & Shoulders Pattern

H&S patterns are considered highly reliable reversals by Edwards and Magee. Bulkowski ranks this reversal pattern as the second most reliable behind diamond formations, providing returns 19% greater than a buy and hold approach for the S&P 500 versus diamond formations with returns 24% greater than a buy and hold approach using the S&P 500.¹

In addition, Andrew W. Lo, PhD, Director of MIT’s Laboratory for Financial Engineering, has written about the reliability of the pattern for stocks when it is one detectable by algorithm. While the statistical significant conclusion that the pattern provides “incremental information” is not one likely to be used by marketing departments to describe a product, it does speak to the existence of a specific form of the pattern which does lead to a reversal.²

• At tops these patterns are referred to as a H&S pattern or a Complex H&S pattern—with multiple heads and/or shoulders.
• At bottoms they are referred to as Inverse (Complex) Head & Shoulder patterns.

A pattern that appears to be an inverse H&S, but occurs during a bullish trend is considered a Continuation H&S with price expected to resolve itself with price breaking up above the pattern.

Pattern Development

Using the daily chart,

• H&S top forms with an initial move upward in prices on good volume that reach new highs (left shoulder).
• Prices retrace and make a second move upward to new highs (head) which may be on less volume.
• A second retracement occurs to a level below the first high achieved and often to a level that approximates the previous retracement.
• A third rally occurs that fails to reach a new high (right shoulder) and is accompanied by noticeably less volume.
• When prices retrace from this level volume increases towards a supporting trendline drawn using the first two retracement lows (neckline).

A break of the neckline by 3% indicates a move out of the pattern. Prices may continue downward from there or move back up to test the pattern neckline. Decreasing volume on the advance to the neckline may provide a good low risk entry point since such conditions favor a reversal in price. The projected move is minimally the same distance as that measured from high achieved in the formation of the head to the neckline level below it.

Although I cannot quickly track the reference in this revised article, I believe H&S patterns are deemed more reliable when the supporting neckline is trending downward and Inverse H&S patterns are deemed more reliable when the resisting neckline is trending upward.

Inverse Head & Shoulders Example (2008-2009)

From approximately December 2008 through July 2009 a successful complex, inverse H&S pattern developed in SPY, the Standard & Poor’s Depository Receipts^TM (SPDR^®) product which tracks the widely followed S&P 500^® Index. This pattern included the March 2009 low as the trough of the head. While the volume requirements are slightly different for bottom reversals, Figure 1 provides a nice visual of the pattern.

Figure 1 Inverse H&S Reversal Pattern on Daily SPY Line Chart (2008-2009)

The alternate level of 121.24 was also reached.

Head & Shoulders Example (2010)

In late May 2010 a potential pattern throwback for XLE, the S&P Select Sector SPDRs^TM for energy, was taking place. Figure 2a provides the H&S reversal pattern that formed and highlights the real-time challenge faced when assessing charts. The pattern was valid by definition, but failed to make a valid move to the projection before closing back up above the neckline.

Figure 2a Potential H&S Top Forming on XLE

Figure 2b Resolution for H&S Top Forming on XLE

Keep in mind that even reliable patterns are not guarantees.

QQQ Potential Head & Shoulders Pattern

 The last figure provides a current weekly view of QQQ, the NASDAQ-100^® Index tracking exchange-traded fund [ETF]. Here a potential H&S is forming; however, it should be noted: 

• The right shoulder volume may be providing an early indication that the H&S will not unfold
• The upward sloping neckline may not be optimal for reaching a measured move should the pattern continue to evolve.

Forming on Weekly QQQ

Figure 3 Potential Head & Shouders Pattern

Periodic updates on this pattern will be provided as developmens unfold.

¹ Kirkpatrick, C. CMT & Dahlquist, J. PhD (2006). Technical Analysis: The Complete Resource for Financial Market Technicians (p 338). Upper Saddle River, NJ: FT Press

² Lo, A., Mamaysky, H. & Wang, J. (2000). Foundations of Technical Analysis: Computational Algorithms, Statistical Inference and Empirical Implementation. The Journal of Finance, Vol. LV, No. 4, 1753.

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

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