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Thursday, October 13, 2005
Head and Shoulder Reversal Patterns (Technical Analysis)
A head and shoulders reversal pattern is a common and reliable reversal pattern, possibly the most reliable. Learning this pattern will definitely advance your stock trading ability. In fact, head and shoulders reversals can be used as technical analysis indications for day trading and options trading on any time scale. Here is an example of a head and shoulders pattern:
Notice that in the example, both price and volume are reflected. You may wonder why some volume bars are green and some are red. This is only to illustrate a difference between high and low levels of volume. Volume plays an important role in the Head and Shoulders Reversal Pattern.
To begin, let’s first identify the parts of the pattern. The peak at A is the left shoulder. The peak at C is the head and the peak at E is the right shoulder. From points B and D we can draw a line—this is called the neckline and plays a critical role in the completion and confirmation of this pattern.
At point A, we appear to be in a continuation of the uptrend marked by the yellow line. Even at point B, we are still in this uptrend. Remember, that in order for a reversal to take place, a previous trend must exist. You cannot have a reversal without a trend.
Our first warning sign comes from B to C, when the uptrend continues, but on lighter volume. When we break the uptrend (between C and D) on higher volume, we are again alerted to a possible problem in the trend. As prices rebound off of D and move upwards towards E, we notice that the up move again comes on light volume. When we reach E and begin moving down we notice that we’ve completely broken the uptrend, and may be forming a new downtrend. After all, E is lower than C, so we may have the beginning of a new downtrend.
However, the Head and Shoulders Reversal Pattern is not complete until we break the neck line, between E and F. The neck line is drawn from points B and D. Once we break this neckline (decisively, usually with 1-3% penetration), the head and shoulders pattern is confirmed. This is usually done on higher volume (E to F) and is very often followed by a return move (G) on light volume to or near the neckline. This is an excellent short selling opportunity. Following the return move, you can expect heavy volume selling to push to price lower. This begins a new trend, downward.
Key points to the Head and Shoulders Reversal:
· A prior trend must be in place for a reversal to occur.
· Uptrend continues, but on weaker volume (B to C)
· Heavy selling pushes point D below the trend line.
· The right shoulder is formed, lower than the head and on light volume.
· The neck line must be broken decisively to complete the pattern.
· A return move is very common, on light volume. Short at or near the neck line.
Notice that in the example, both price and volume are reflected. You may wonder why some volume bars are green and some are red. This is only to illustrate a difference between high and low levels of volume. Volume plays an important role in the Head and Shoulders Reversal Pattern.
To begin, let’s first identify the parts of the pattern. The peak at A is the left shoulder. The peak at C is the head and the peak at E is the right shoulder. From points B and D we can draw a line—this is called the neckline and plays a critical role in the completion and confirmation of this pattern.
At point A, we appear to be in a continuation of the uptrend marked by the yellow line. Even at point B, we are still in this uptrend. Remember, that in order for a reversal to take place, a previous trend must exist. You cannot have a reversal without a trend.
Our first warning sign comes from B to C, when the uptrend continues, but on lighter volume. When we break the uptrend (between C and D) on higher volume, we are again alerted to a possible problem in the trend. As prices rebound off of D and move upwards towards E, we notice that the up move again comes on light volume. When we reach E and begin moving down we notice that we’ve completely broken the uptrend, and may be forming a new downtrend. After all, E is lower than C, so we may have the beginning of a new downtrend.
However, the Head and Shoulders Reversal Pattern is not complete until we break the neck line, between E and F. The neck line is drawn from points B and D. Once we break this neckline (decisively, usually with 1-3% penetration), the head and shoulders pattern is confirmed. This is usually done on higher volume (E to F) and is very often followed by a return move (G) on light volume to or near the neckline. This is an excellent short selling opportunity. Following the return move, you can expect heavy volume selling to push to price lower. This begins a new trend, downward.
Key points to the Head and Shoulders Reversal:
· A prior trend must be in place for a reversal to occur.
· Uptrend continues, but on weaker volume (B to C)
· Heavy selling pushes point D below the trend line.
· The right shoulder is formed, lower than the head and on light volume.
· The neck line must be broken decisively to complete the pattern.
· A return move is very common, on light volume. Short at or near the neck line.
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