The Head and Shoulders Pattern
The head and shoulders pattern is generally regarded as a reversal pattern
and it is most often seen in uptrends. It is also most reliable when found
in an uptrend as well. Eventually, the market begins to slow down and the
forces of supply and demand are generally considered in balance. Sellers
come in at the highs (left shoulder) and the downside is probed (beginning
neckline.) Buyers soon return to the market and ultimately push through to
new highs (head.) However, the new highs are quickly turned back and the
downside is tested again (continuing neckline.)
Tentative buying re-emerges
and the market rallies once more, but fails to take out the previous high.
(This last top is considered the right shoulder.) Buying dries up and the
market tests the downside yet again.
Your trendline for this pattern should
be drawn from the beginning neckline to the continuing neckline. (Volume has
a greater importance in the head and shoulders pattern in comparison to
other patterns. Volume generally follows the price higher on the left
shoulder. However, the head is formed on diminished volume indicating the
buyers aren't as aggressive as they once were. And on the last rallying
attempt-the left shoulder-volume is even lighter than on the head, signaling
that the buyers may have exhausted themselves.) New selling comes in and
previous buyers get out. The pattern is complete when the market breaks the
neckline. (Volume should increase on the breakout.)
This pattern can be used on charts of various time frames from minutes to
daily or even weekly charts.
Our charts are 60 minute charts.
Let’s look at Costco Wholesale Corp. (NASDAQ: COST).
Head and Shoulders Pattern:
A major reversal pattern with four distinct features:
Left Shoulder:
The trading of May 15, 2000 is our left shoulder.
Head:
A high volume rally with the top reaching a higher level than the left
shoulder, followed by a another reaction on less volume that takes the price
to a level near the bottom of the previous reaction. This time frame is May
16, 2000 price action.
Right Shoulder:
The right shoulder can be a channel a little above or a little below the
left shoulder.
Neckline:
A decline in prices from the bottom of the shoulders which falls below the
line formed when connecting the bottoms of the left shoulder. This is drawn
by connecting the bottom around 47 of the left should on May 15 and the
bottom of right shoulder at 47.
The break late today makes COST a Sell using this pattern.
I would short COST here.
I would place a stop at 48 �.
