head and shoulders pattern
is a highly-reliable technical formation that signifies a reversal
in a stock's trend.
As you can see in the figure below, the pattern is named because
it looks like a person's head and shoulders.
The head and shoulders pattern consists of four distinct parts:
The left shoulder, the head, the right shoulder, and the neckline.
Each of these four must be present for the formation to exist.
The Left Shoulder:
Visualize a stock rising from $55 to $85, a gain of more than +50%.
Next, suppose the stock then hits a short-term peak and forms a
doji candle on the heaviest volume in several months. The left
shoulder often starts with a period of heavy volume. Then, the
stock moves sideways between $80 and $85 for several weeks.
After several weeks of
, assume that a low volume breakout to just under $90 occurs. Note
that the head ($90) is noticeably above the left shoulder ($85). It
should "stick out" as part of the pattern. Volume on this new high
should ideally be below the volume of the left shoulder. This is
negative volume divergence, which occurs when price goes to a new
high, but volume does not make a corresponding peak -- a key
The Right Shoulder:
Immediately after the peak near $90, there should a high volume
sell-off, with the stock pulling back to just above $80 support.
The shares will then rally back to $85 on tepid volume.
In this particular example, what I've identified as $80 support is
actually the neckline of the head and shoulders formation. The
neckline is drawn across the lows of the left and right shoulders.
Most frequently, it is drawn horizontally, but it can also be drawn
diagonally, sloping either up or down. When the neckline is broken,
the stock is in a confirmed head and shoulders pattern. Sometimes a
"filter" of either 3% or two trading days is necessary to insure
that the pattern is not a "false breakout" to the
Often a stock will retest the neckline. If the pattern is a
genuine head and shoulders, it will typically fail at the previous
neckline and offer a second shorting opportunity.
The Inverted Head and Shoulders Pattern
The head and shoulders pattern can also be inverted. In this case,
the formation is bullish because it appears downwards, signifying
the breaking of a downtrend.
With the inverted head and shoulders pattern, buying and selling
activity, as well as volume, are opposite.
The inverted left shoulder is created on increased volume. The
inverted head will be formed on lighter volume. However, the rally
from the head to the peak of the right shoulder will typically
occur with greater volume than seen during the creation of the left
shoulder. Once the peak of the right shoulder has formed, volume
will dramatically decline. But, as the stock pushes past the
neckline, volume will spike, along with the stock price.
Applying the Head and Shoulders Pattern
The 3-year weekly chart of Mexican housing development company
Homex Development Corp (
) provides a good example of both the inverted and traditional head
and shoulders formations.
As shown on the chart, an inverted head and shoulders pattern
began forming in early January 2009. The left shoulder was created
during relatively low volume. The head formed as the stock -- and
the rest of the market -- tumbled to a low in March. Price and
volume both increased as the right shoulder formed in May. The
stock rallied through the neckline and gained nearly +40%, going
from $25 to $35 in four months.
But just as HXM reached $35 in the fall of 2009, its technical
direction began to change. At this point the stock filled in a gap
that occurred in late September 2009. Soon after, the left shoulder
of the traditional head and shoulder pattern formed. The head
appeared in October as the stock went to a high of $45. At this
, the peso, was up +4.4% from the previous month, boosting Mexican
companies as a whole.
However, after the stock hit $45, it encountered resistance. The
$45 area had been a support area in mid-2007 to early 2008. Old
support had turned into new resistance. After a small head formed,
the shares began to fall rapidly, forming the right shoulder
between roughly $32 and $36. In late-January to early-February
2010, HXM fell hit $30, forming the neckline of pattern. The
neckline is seen by drawing a line through the lowest point of each
shoulder. In February, the stock broke below the neckline at $30
and fell rapidly. However, technical theory says HXM has much
further to drop.
To calculate how much HXM will go down, we can apply the head
. We first calculate the breakout by measuring from the top of the
head down to the neckline ($45 - $32 = $13). Next, we subtract the
neckline from the breakout to obtain our target ($32 - $13 = $19).
Our target price is therefore $19.