Technical analysis can often confuse the buyer or seller of stock from the important fundamentals. Warren Buffett and Benjamin Graham do not believe in using chart patterns unless it allows you to buy the stock at a lower price and/or sell at a higher price because the fact is, stocks are a peice of the company. It makes no business sense to buy a stock for long term because it’s priced higher. Such practice is trying to hope on a trend and it is speculation that such a trend will continue, and therefore more risky.
The reason a head and shoulder pattern is so effective because first you have a stock moving upwards, the stock then dips as is normal behavior. The stock then tries to resume it’s rally, and succeeds, most likely going higher than it should as the next result is that it trades all the way down to it’s previous pull back. This is an indication that the stock is no longer trending up. Additionally, such a violent move to the downside following a large move to the upside indicates that there is a major sychological battle between the bears and the bulls and a very big difference in where the buyers and sellers think the stock should go. It is usually likely that a high growth stock has either had too much optomism, or that at some point the growth will slow. the smart investors realize the initial spike in the first shoulder was a great time to sell, and although the buyers overpower them, they still sell and over power the buyers. They use the next spike to sell, and if the right shoulder is lower than the left shoulder or equal to it, it is a longer term sign that the stock will start to trend sideways or downwards. Measuring the peak of the “head” compared to the right shoulder will also show a downward decline.
If you follow the Buffett mantra of “profit from folly, don’t participate in it” you will recognize that that is exactly what someone on the sellingside is doing. The continuous upward slope shows that there is a large amount of speculation that the stock will go higher, otherwise it would have a more moderate increase. The buyers often get lulled into a false sense of security forever buying the stock higher, and using any pullback to buy more shares. They can often get detached from the fundamental reason of why they are buying such a stock. Such buyers are more and more speculative bidding the price higher. Regardless of if you understand the reason behind this price action, the actual facts are that the head and shoulders patterns are the most reliable chart pattern known. It is said that it has been over 90% accurate throughout a very long period of history.
Head and Shoulders Sell Signals:
There are generally two entry points to a head and shoulders pattern. The first is early anticipation. This should be done when the right shoulder reaches it’s “peak or nears it. This is an excellent spot to anticipate a breakdown, because if you’re wrong and the stock or index finds support, you can still make a profit. You can actually await for the breakdown and only cover your positions if the stock breaches your initial sell point. If you buy a stock, you can sell some shares at the same anticipitory point and buy shares later if they approach those prices again.
The second point is a much higher probability bet and that’s getting your puts and shorts and betting against the stock or index AFTER the breakdown has confirmed. It is not an official Head and shoulders” until it has breached below the neckline after the head and both shoulders have formed.
Head and Shoulders Continuation patterns:
However, because head and shoulders are so accurate, it is generally believed to be a more accurate price pattern as a continuation pattern following a head and shoudlers pattern than a less reliable chart pattern.
Head and Shoulders Price Target:
I prefer to take a more conservative approach to the head and shoulders price target. The initial price target should be measured by comparing the peak of the “head” to the “neckline”. The aggressive approach is to just measure the difference of the top to the bottom. If the S&P peak is 1000 and the neckline is 800 the projected downside is 600. On the other hand if you take a more conservative approach, the target is instead the percentage difference, or in this case 20% lower than 800 a price target of 640.
Head and Shoulders of today’s market:
The head and shoudlers pattern can be see forming in today’s market. It can be seen in the 2008 peak and following collapse, and from April’s 2010 peak you will notice that both shoulders and head has formed although we are currently testing the support and have yet to have a comfirmed breakdown. What you also may see if you look at a longer term chart is that with 2008 as the peak and 2000 as the left shoulder and April 2010 as the left shoulder, there is the potential for a very long term head and shoulders pattern if in fact this trend continues.
If you take just the price target from the peak of 2010 while looking at the shoulders, the peak is around 11,100 in the dow and the neckline is around 9875. You can take 9875 divided by 11100 and get about .89 and multiply that by 9875 giving you a rough estimate of around 8800 for a conservative price target. Please note that the actual neckline has not been breached yet and is testing support along with the charts in the S&P and nasdaq showing the same thing.
Head and shoulders pattern and fractals:
Fractals are a very interesting thing and can potentially be more supporting evidence that the pattern will in fact break down. Fractals are defined as a rough or fragmented geometric shape that can be split into parts, each of which is (at least approximately) a reduced-size copy of the whole
Here we see a rough example. The head and shoulders pattern can be seen by going into more detail by looking at the head of this pattern. We can see that within the head there is a smaller head and shoulders and within the shoulder there is a smaller head and shoudlers. Within each of these heads there is a smaller head and shoudlers and within each of these shoulders there is also a smaller head and shoudlers pattern. It may be less and less visable if you don’t actually adjust the time interval on which the pattern is displayed, but if you were to adjust them and instead show 1 minute intervales the pattern would be more clear. If the smaller pattern is contained in the whole and the completion of the smaller pattern results in the stock going lower, it is more likely that the stocks will go lower and confirm the pattern as history suggests, and ultimately making a confirmation of an even larger pattern.
Errors in head and shoulders price targets
There are other ways of making price targets. For example, you can simply look at previous head and shoulders patterns and resize the image so that it fits with the current pattern. You should generally do this when charting patterns on a logrithmic scale, otherwise you will potentially have price targets below zero which is impossible. For example, if the markets were to trend downwards until it breaks the 2008 lows and continues downward we would hve a very large head and shoulders pattern. If this pattern occurs one way to project a target would be to look at 2008′s head and shoulders pattern which declined from over 14,000 to under 7000. Even just by a decline of the same magnitude would put the stock market at 0 which is impossible. However because the chart is larger and the distance from the 2008 head to the neckline was only about 3000 and yet it resulted in a decline from it’s neckline of around 11,000 to it’s bottom of 6500 and now the difference of the peak of 14,000 and the neckline of 6500 is 7500 which is over twice as much, the resulting decline should span over a longer period of time and be more severe by twice as much. In a non logrithmic scale this results in a decline of over 9,000 from it’s neckline of 6500 which is impossible. Depending on how you line up the chart you could even end up with a projection of negative 9,000 which shows how ridiculous using a non logrithmic price target is.
A more realistic target would be to say that the peak of 2008 went from 14,000 to the bottom of under 6500 this is roughly 60% decay from the shoudlers of roughly 11,000. Now a similar decay of 60% from the shoudlers of around 6000 would put the target roughly at Dow 4,000 if we do in fact break the neckline.If you use the way of forming the price target by instead showing percentages from peack to neckline, you could end up with around a target of Dow to 3500. Generally I would go with the most conservative target so as not to miss out on an opportunity to take profits. When in doubt, always take profits earlier than your target to avoid being greedy, and cut your losses at any sign that the pattern isn’t following the downward trendline which is formed by extending the points of the peak of the head and the right shoulder.
Also, it shouldn’t be assumed that because the fractal is there that the price target will break. Especially when the first price target of the first breakdown which hasn’t occured yet. Additionally, for we all know, after testing support stocks could rally to 12,000 or so and what looks like a head and shoulders now could actually just become the “shoulder” of a larger head and shoudlers. The fractal pattern could continue, but stocks may need to go higher before it forms the “head within the larger pattern within the pattern.
There’s a danger with fractals. The pattern may not be done yet if it doesn’t break down it could just be a smaller peice fractal within an even larger peice. What looks like it will be the ultimate size of the fractal with all of it’s fractals within may in fact be only part of an even larger fractal.
Possibly we hold support and even rally to 12,500, then over time dip back down to current levels, at which point we rebound around April’s highs. Thus this is merely the “pattern” within the larger pattern of head and shoulers as what we look at as the “head and shoulders” merely becomes the “left shoulder” of a larger head and shoulders which makes up the right shoulder. We could still rally to 12500 and stay in the confines of “fractals”. Technically at some point we could even rally to something like 16,000 which becomes an even larger fractal within the fractal. Take a look at a hypothetical fractal market. Note how the support holds and instead of breaking down it rallies much higher to fom the ultimate head and shoulders which occurs at much higher prices. This is why it’s important to wait for confirmation of a break down.
Using bearish price targets as buy points:
I am not famriliar with whether or not anyone has come up with this idea before. The idea is that head and shoulders pattern have price targets that are lower than the current price. If you notice a stock with a head and shoulders price target, rather than selling it, you can use the pattern to set a limit order at your initial price target, if the fundamentals of the company behind the stock are strong enough. If nothing else, you can at the very least can stocks you would wish to purchase for head and shoulders patterns and use the head and shoulders pattern to acvoid purchasing the stock at current price andinstead waiting until it pulls back.
It could very well be that there is no fundamental reason for the head and shoulders breakdown and it is instead investors over reacting. It is important to understand the reason behind the chart pattern and see if ti makes sense. If there is any sort of news at the top, and evidence of growth in sales or earnings slowing, or any reason for a bearish decline, it is likely seen by some as a sign of things to come. If there is no reason, you may want to be a little more careful, however the history of head and shoulders chart patterns is very good so even if you are a fundamental investor, you may want to make an exception for a head and shoulders pattern.
good post. Looks like we’re rallying above the breakdown point, but we’re still within the confines of the new downtrend.
Yep, that’s true. We are now retresting the downtrend, I will make a post describing some more things shortly…
edit:
http://stocktradinginvestments.com/short-the-retest-of-the-head-and-shoulders-breakdown/