Wednesday, November 14, 2012

Head & Shoulders - The Truth

P.S. A special Emerging Markets report will be published tomorrow. So if you have read the article on Head and Shoulders, thank you for waiting. And if you have not read the following article on Head and Shoulders, it will be a good segway into next 3-4 articles on globals markets. 
The Head & Shoulders (H&S) formation consists of a left shoulder, a head, and a right shoulder and a line drawn as the neckline. It typically indicates a trend change. We have experienced several H&S completed at various degrees of trends prior to major tops, such as 2007 top, 2000 top etc.

File:H and s top new.jpg

The left shoulder is formed at the end of an extensive move during which volume is noticeably high.
After the peak of the left shoulder is formed, there is a subsequent reaction and prices slide down to a certain extent which generally occurs on low volume.

The prices rally up to form the head with normal or heavy volume and subsequent reaction downward is accompanied with lesser volume.

The right shoulder is formed when prices move up again but remain below the central peak called the Head and fall down nearly equal to the first valley between the left shoulder and the head or at least below the peak of the left shoulder. Volume is lesser in the right shoulder formation compared to the left shoulder and the head formation.

A neckline is drawn across the bottoms of the left shoulder, the head and the right shoulder. When prices break through this neckline and keep on falling after forming the right shoulder, it is the ultimate confirmation of the completion of the Head and Shoulders Top formation. H&S necklines can be down sloping or up sloping, depending to the severity of the trend.

Neckline Break: The head and shoulders pattern is not complete and the uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincing manner, with a high increase in volume.

Support Turned Resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break, and offer a second chance to sell.

Price Target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a price target. Any price target should serve as a rough guide.


  • All H&S patterns do not result in sharp declines. If a pattern is shorter in duration, it might just be a continuation pattern. On the other hand, if the pattern is longer in duration, it would suggest a market top is at hand.
  • H&S patterns graphically portray the distribution that takes place at market tops, from stronger hands to weaker hands. Throughout this pattern, prices remain in a tight range because both buyers and sellers fight out for the true price of the asset. Typically, people who owned the stock since the bottom want to sell their positions and lock in profits. Whereas, those who initially missed the boat want to buy in. Soon thereafter, all the buyers are exhausted from the market place and only sellers remain. This lack of demand pushes the market down to the next level of support because the volume needed to drive the stock prices higher is absent. As a result, the right shoulder is usually lower than the head. Finally, when the market comes back to the neckline for the 3rd time in the right shoulder, it breaks below the neckline. This break often results in a sharp decline of prices.
In the next article we will be analyzing the impact of the H&S formation in the Emerging Markets chart (as of today) and its probable consequences on the global economy.


  1. Naqvi, I like the format and instruction! I have a question for the bloggers. It seems the "waves" in your prior post show a potential rise into Thanksgiving (not surprising), but then another drop. If the second IPM window continues out into December sometime, that could coincide with the ending/settling/kicking the can down the road of the "Fiscal Cliff" and the rally could be huge. It seems that for a long time now (since QEs), the market has exited from its roll as a barameter of the US/Asia/Japanese/world economy, for a role as the barameter of political policy (or lack thereof). Any thoughts?

    My other thought, any bounce will be short lived at best, better to see how fiscal cliff drama plays out before jumping in with both feet.

    How ever you decide to place your bets, be careful out there... Brad

  2. You are correct that the stock market is becoming a barometer of politics rather than the economy, and it is because the market is forcing the politicians to take actions rather than politicians taking actions on their own. From a social miss perspective, this is what really happens. The market governs the actions and not the political decisions. But in case of the US market we are seeing a lot of this kind of behavior primarily because we are so concerned with the US market. If we were not concerned with the US market and had treated it like any other market it would be difficult to see the correlation except for all major political decisions were made after the market had declined.

    Overall,theses are very demanding times and slacking congress during this time period is not helping the overall economic issue.


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