The Power of the Head and Shoulders

Of the various types of chart patterns that we trade, the Head and Shoulders is one of the most reliable and profitable types of setups. Since several of the major market indices are currently in the process of completing a Head and Shoulders pattern on their daily charts, we figured this is an ideal time to discuss how to identify the pattern and capitalize on it. As such, we postponed our weekly ETF analysis in order to bring you this timely educational article, but will resume with our weekly ETF analysis and discussion next week. Let's begin by looking at a basic diagram of a Head and Shoulders pattern:



A Head and Shoulders pattern (hereafter H&S) is a bearish reversal chart pattern that often marks the top of an uptrend and predicts a selloff in a particular index or ETF. The left shoulder and head are formed as the index is rallying and does not indicate anything bearish. However, once the neckline is formed on the right side of the head, that is our first warning point that the buying momentum has slowed because rather than setting a higher low on the previous rally, the index sells off all the way down to the prior low. When this occurs, people who bought near the top (the head) are now trapped in the long position. Then, as another wave of buyers attempt to rally the index, the people who are trapped long at the top sell into the rally in an attempt to just come close to breaking even. This weakens the index even more, which prevents the achievement of a higher high and also forms the right shoulder. This usually marks a break of the uptrend as the index comes back down once again and tests the prior low. At this point, everyone who bought on the left shoulder, head, and right shoulder are now trapped and out of the money in their positions. So guess what happens? They begin to sell, which causes a break of the neckline, which subsequently causes a rapid and often volatile collapse of the price due to selling momentum.

Although the most ideal entry point for shorting a H&S pattern can be debated, we prefer to enter after the right shoulder has been formed and starts back down to the neckline. If you enter before the right shoulder is formed, there is not enough confirmation that there really is a H&S pattern being formed, so you will often stop yourself out by shorting too soon. On the other hand, if you wait for the neckline to break before selling short, your entry price is not that great and can often result in getting shaken out of the position right before it cracks or missing the selloff altogether. However, by shorting after the right shoulder has been formed and the price starts coming back down, you are essentially selling into strength, which gives you a lower risk and higher profit entry point. If the H&S fails and does not follow through, your losses are also reduced because you shorted at a decent price. Remember that the goal of our trading strategy is not to squeeze every single dollar of profit out of a trade, but rather to catch a bulk of the profits with minimal risk.

When a H&S drops below the neckline (which is sometimes ascending or descending), the predicted selloff amount is usually equal to the distance from the top of the head down to the neckline. So, if the price at the top of the head is $100 and the price at the neckline is $90, the predicted drop would be equal to $10 (100 - 90) below the neckline. Since the neckline is $90, the predicted selloff is down to $80. This is a guideline you can use to determine a target price for where to take profits on a short setup.

Although H&S patterns follow-through a majority of the time, there are occasions when the pattern fails, meaning that it never drops below the neckline after forming the right shoulder. A failed H&S pattern occurs when the price rallies above the high of the head after forming the right shoulder. When the price rallies above the head, make sure you quickly cut your losses if you are short because the move is usually strong if there were enough buyers to propel through all that resistance and set a new high. After getting through the resistance of the H&S pattern, the failed short setup often becomes a great long play. Here is an example of a failed H&S:



One indicator you can use to assist in determining the probability of whether or not the H&S will follow-through is volume. As with every other type of chart pattern, volume is the most critical type of technical analysis, and this pattern is no different. Specifically, what we look for is lighter volume on the right shoulder than on the left shoulder. If volume on the formation of the right shoulder is significantly less than the volume that formed the left shoulder, it indicates there are less buyers to rally the index, which increases the probability of coming back down to test the neckline and eventually breaking below it. Conversely, increasing volume on the right shoulder is often a warning sign that the pattern may not follow-through and we will need to cover our shorts if the right shoulder ends up breaking above the head.

It is important to realize that the amount of time it takes an index or ETF to complete the breakdown of the H&S pattern is largely dependent on the time frame of which the setup occurs. For example, a H&S pattern that sets up on a 5-minute intraday chart will usually follow through and complete the selloff within a few hours. However, if you see a H&S on a sixty-minute chart, it will probably take several days or even a week to complete the predicted drop. A H&S on a daily chart will usually take weeks or even months to follow-through. Therefore, if you see a H&S pattern on a daily chart, it's typically not as easy as blindly going short unless you are the type of trader who can stomach volatility. If you short a H&S on a daily chart, you will probably stop yourself out unless you allow the setup a significant amount of time and price volatility before it follows-through. Because of this, we prefer to trade H&S patterns that occur on shorter time frames such as 15 or 60 minute charts. These make for ideal swing trades on the short side and are often the source of short setups for ETFs listed in The Wagner Daily.

There is a bullish variation of the H&S pattern that is called an Inverse Head and Shoulders pattern. This pattern is identical to the H&S pattern detailed above except that it is flipped upside down. The predicted move to the upside is also the distance from the head to the neckline, just like with a regular H&S. Here is an example:



Finally, let's put everything you have learned together to look at an actual chart of a H&S pattern where the neckline was recently broken. Below is the exact chart that we published in the September 16 issue of The Wagner Daily, where we discussed the possibility of the H&S pattern following through:



Now, here's a look at where the S&P (SPY) is exactly one week later:



After studying the daily chart of SPY (S&P 500 Tracking Stock SPDR) above, you will probably get a better understanding of why we have seen broad selling during the past several days. Whether or not SPY will see the predicted target of just under 81 is a crapshoot because the markets are oversold in the short term and due for a bounce within the next several days. However, the bounce could be shortlived. One thing is for certain though and that is Head and Shoulders patterns work!