Probably the most popular and misdiagnosed chart reversal pattern is the head and shoulders. The basic pattern consists of a rally on good volume to new highs followed by a setback on lighter volume. This marks the left shoulder of the formation. The market then resumes its advance, again on decent volume, to make new highs. A correction follows somewhat similar in price and time as the previous setback, to create the head. Finally a third rally on light volume fails to make new highs and price falls back to create the right shoulder. A line between the lows of the two corrections is then drawn and extended to the right. This then represents the neckline. It is a penetration of the neckline by price that confirms the pattern and signals the trader that the market has indeed reversed.
There are two characteristics of head and shoulder patterns that Edwards and Magee emphasized as critical in their identification that most market pundits overlook. These are volume and symmetry. As I have already emphasized it is important that volume on the left shoulder be lower than on the right or the head. Remember that volume represents the sense of urgency or enthusiasm that market participant’s experience. Lower volume on the third and failing wave of a head and shoulder pattern (the left shoulder) exemplifies the dwindling conviction of market bulls.
Monthly Japanese Yen
In the chart above notice how volume on the rallies to both (A) & (B) were significantly stronger than at (C). The second factor that often goes overlooked when identifying a head and shoulders pattern is symmetry. A valid formation will tend to have symmetrical right and left shoulders in both price and time. That means that the distance from the high bar on the left shoulder to the head, should be about the same as the difference from the right shoulder to the head. In the yen chart above you can see that from (A) to (B) the distance is 10 bars while that from (B) to (C) is 11. Once a head and shoulders pattern has signaled a reversal by breaking the neckline, the trader can make a measurement off the pattern to determine the minimum extent of the expected move. By measuring the distance between the low made the day that the head was formed at (B) and the neckline on the same day, one can expect a move of equal distance from the point of the breakout. In our example above, the low on the day the high was made came in at 126.00. The vertical distance between that point and the neckline at 118.50 gives a measured move of 7.50. Subtracting that distance from the neckline at the breakout point of 121.00 projects a minimum move to the 113.50 level, an objective that the market blew through in January 2013. Before moving on I want to point out that head and shoulders can also form at bottoms as well as tops. Head and shoulder patterns can be very excellent trading opportunities. The key is making sure to watch the volume and symmetry.