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26 Head-and-Shoulders Tops H LS

RS

RESULTS SNAPSHOT Downward Breakouts Appearance

Three-peak formation with center peak taller than the others.

Reversal or continuation

Short-term bearish reversal Bull Market

Bear Market

Performance rank

1 out of 21

6 out of 21

Break-even failure rate

4%

1%

Average decline

22%

29%

Change after trend ends

51%

45%

Volume trend

Downward

Downward

Pullbacks

50%

64%

Percentage meeting price target

55%

56%

Surprising findings

Pullbacks hurt performance. Tall or narrow patterns perform better than short or wide ones. Patterns with a rising volume trend, U shape, and heavy breakout volume outperform. When volume is highest on the head, the pattern performs well. Patterns with a horizontal neckline or higher left shoulder tend to outperform.

See also

Head-and-Shoulders Tops, Complex

405


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Of all the chart patterns in this book, the head-and-shoulders top (HST) is perhaps the most popular. This stems from its reliability, performance, and easy identification. In a bear market, the performance shines with just 1% of the patterns failing to drop more than 5% after the breakout, and the average decline measures a large 29%. Traders not versed in chart patterns can guess what a head-and-shoulders top looks like and get it right. Surprises for HSTs are many but all are self-explanatory. If not, I discuss them later in the chapter anyway.

Tour Figure 26.1 shows a good example of a head-and-shoulders top. The three bumps are clearly visible, with the center bump being the highest of the three. The left shoulder usually appears after an extended uphill run. The entire formation seems to stand alone when viewed in the context of a year’s worth of daily price data. This stand-alone characteristic makes the head-and-shoulders top easily identified in a price series. Figure 26.1 shows the highest volume occurring during the head. More often the left shoulder has the highest volume, followed by the head, with greatly diminished volume during formation of the right shoulder. The identification guidelines are flexible because volume characteristics vary from formation to formation.

Great Atlantic and Pacific (Grocery, NYSE, GAP)

– 36

Head

– 35 – 34 Right Shoulder

Left Shoulder

– 33 – 32 Pullback

– 31 – 30 – 29 – 28

Neckline

– 27 – 26 – 25

Head

– 24

Left Shoulder

– 23 – 22

Right Shoulder Mar 93

Apr

May

Jun

Jul

Aug

– 21 Sep

– 20 Oct

Figure 26.1 A head-and-shoulders top formation where the center peak towers above the other two. A pullback to the neckline occurs frequently.


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A trend line drawn along the bottoms of the two troughs between the three peaks forms the neckline. The line may slope in any direction but slopes upward about 52% of the time and downward 45% of the time with the remainder being horizontal. The direction of neckline slope is a predictor of the severity of the price decline. Why do these chart patterns form? Pretend for a moment that you are a big spender and represent what is commonly called the smart money. You are searching for a stock to buy and believe that Toll Brothers (Figure 26.2) represents an intriguing situation. You review the fundamentals and everything looks good, so you start buying the stock in mid-July as prices descend. Your buying turns the situation around: The stock begins rising. Soon you have acquired all the stock you want and sit back and wait. As you expected, the company issues good news and the stock begins making its move. Other investors jump into the game and buy the stock, sending the price higher. As the stock rises above 10, you decide it is time to sell. After all, you have made 20% in about 2 weeks. Your selling causes the stock to pause then begin a retrace of the prior action. Sensing weakness in the stock, you stop selling and monitor the situation closely. Other momentum and buy-the-dip players, believing that this is a chance to get in on the ground floor of a further advance, buy the stock on the retrace. The decline halts and the stock begins rising again. As it rises, additional momentum players make a bid for the stock or buy it outright. Once the stock gets above 10, you begin selling it again, not Toll Brothers (Homebuilding, NYSE, TOL)

– 12

Head Right Shoulder

Left Shoulder

– 11

– 10

Support Level Neckline

– 9

– 8 Left Shoulder Head

Right Shoulder

– 7

– 6 Jun 92

Jul

Aug

Sep

Oct

Figure 26.2 Volume pattern of this head-and-shoulders top obeys the general characteristics: highest on formation of the left shoulder and weakest on the right shoulder. The down-sloping neckline suggests an especially weak situation.


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heavily at first because you have a large number of shares to dump. Still, the market players notice your selling and the stock climbs just above 11 before heading back down. You dump your remaining shares as the stock begins tumbling. Volume rises as other players sell their shares to unsuspecting buyers. The stock continues moving down and slides back below 10. Believing the stock oversold, demand picks up and sends the price moving up again for the last time. You watch the action from the sidelines, content with the profit you have made. The stock climbs to 10.75 on the right shoulder. Lacking support, the rise falters on weak volume and the stock turns down. Investors versed in technical analysis see the head-and-shoulders top for what it is: a reversal. They quietly take their profits and sell the stock. Others initiate short sales by selling high and hoping the price falls. Prices move down to the support level where prices declined the last time. The stock pauses there for a week and makes a feeble effort to rise again. When the attempt falters, the stock moves down and pierces the neckline. Volume picks up and the stock tumbles. Eventually, prices decline back to where they began, just under 8.

Identification Guidelines Are there certain guidelines that make identifying a head-and-shoulders top easy? Yes, and Table 26.1 lists them. But remember, the identification guidelines are just that, guidelines.

Table 26.1 Identification Characteristics Characteristic

Discussion

Shape

After an upward price trend, the formation appears as three bumps, the center one is the tallest, resembling a bust.

Symmetry

The two shoulders appear at about the same price level. Distance from the shoulders to the head is approximately the same. There can be wide variation in the formation’s appearance, but symmetry is usually a good clue to the veracity of the formation.

Volume

Highest on the left shoulder, followed by the head. The right shoulder shows the lowest volume of the three peaks.

Neckline

Connects the lows of the two troughs between the three peaks. The line can slope up or down. Often used as a trigger point (to buy or sell) once price pierces the line.

Downward breakout

Once price pierces the neckline, it may pull back briefly, then continue moving down.


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Shape. The head-and-shoulders top formation can appear in a wide variety of shapes. Consider Figure 26.3. Shown is a head-and-shoulders top formation, but there are four shoulders and only one head. When a formation appears with more than the standard two shoulders and one head, it is called a complex head-and-shoulders pattern. Complex head-and-shoulders patterns for both tops and bottoms have their own chapters, but many appear in this chapter’s statistics. They are, after all, head-and-shoulder tops, too. The head-and-shoulders top usually appears at the end of a long uptrend. Sometimes, when the prior uptrend is of short duration, the reversal takes prices down to where they started the climb (see Figure 26.2). At other times, the decline is usually short (up to 3 months) or intermediate (3 to 6 months), or can signal a change in the primary bullish trend. The actual length of the decline cannot be predicted. Symmetry. Even though the formation shown in Figure 26.3 is somewhat odd, it does have a symmetrical appearance. The two left shoulders are at about the same price level as the corresponding two right shoulders. Each of the shoulders is approximately the same distance from the other and from its mirror opposite. In the chart pattern, the head is centrally located. The symmetrical appearance of a head-and-shoulders top is one of its key identification characteristics and helps separate any three bumps from a valid head-andshoulders chart pattern. Volume. Volume obeys the following general characteristic: It is higher on the left shoulder than on the head and higher on the head than on the right

Toys R Us (Retail (Special Lines), NYSE, TOY)

– 42

Head Right Shoulder Left Shoulder

Right Shoulder

Left Shoulder

Pullback

– 41 – 40 – 39 – 38 – 37 – 36 – 35

Left Shoulder Left Shoulder

Right Shoulder Right Shoulder

– 34 – 33 – 32

Head

– 31 – 30 – 29 Jun 92

Jul

Aug

Sep

Oct

Figure 26.3 A complex head-and-shoulders top pattern. The chart shows the wide variation that a head-and-shoulders formation can take.


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shoulder. If you consider just the three inner peaks in Figure 26.3, the volume pattern changes somewhat since the left shoulder has volume diminished from that shown during the head. Even so, the volume on the left shoulder is still above the right shoulder. Neckline. The neckline, as shown in Figure 26.3, connects the two troughs between the three inner peaks. It slopes upward but need not do so (contrast with Figure 26.2). The neckline serves as a confirmation point. Once prices pierce the neckline, and assuming they do not pull back, prices continue moving down in earnest. Downward breakout. A pullback to the neckline occurs frequently. It usually takes less than 2 weeks to complete a pullback, but do not be fooled. The trend will resume downward shortly. However, a pullback does allow you one more opportunity to exit a long position or institute a short trade. Take advantage of it.

Focus on Failures Failures of head-and-shoulders formations are rare, but they do occur. Figure 26.4 shows an example of a failure. The well-formed formation has a head centrally located between two shoulders. The left and right shoulders are at the same price level, 29.13. Volume is highest on the left shoulder and lowest on the right, as expected. Hughes Supply Inc. (Retail Building Supply, NYSE, HUG) – 35 – 34 – 33 – 32 – 31

Head

– 30

Right Shoulder

Left Shoulder

– 29 – 28 – 27 Left Shoulder Head

A

– 26 – 25

Right Shoulder

– 24

Nov 95

Dec

Jan 96

Feb

Mar

Apr

– 23 May

Figure 26.4 A rare head-and-shoulders consolidation. The formation fails to continue down after reaching point A. Symmetry and volume patterns offer no clue to the eventual failure.


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Why do prices fail to pierce the neckline at point A and head down? The answer is not clear. The formation is perfect except that it fails to descend. It acts as a consolidation or continuation of the upward trend. Not shown in the figure, the prior two formations were descending triangles. These formations usually break out downward but these did not. Both had upward breakouts and both signaled a bullish uptrend. The two formations were clues to the strength of the rise, but one could also argue that the appearance of a head-and-shoulders formation would probably signal an end to the extended rise. It did not.

Statistics Table 26.2 shows general statistics for HSTs. Number of formations. I found so many HSTs in the stocks I looked at that I quit looking for bull market ones and concentrated on the bear market. Together, I found 814 patterns using 500 stocks from 1991 to 1996 and 200 stocks from 1996 to 2004. Reversal or continuation. A head-and-shoulders top is a reversal, by definition. Price enters the pattern from the bottom and breaks out downward. Thus, price reverses the prevailing trend. Average decline. In a bear market, this pattern does exceptionally well, with declines averaging 29%, well above the 24% decline for bearish chart patterns of all types. Declines over 45%. Bearish chart patterns never show large declines on a continual basis. Even so, having 13% drop more than 45% in a bear market is a respectable showing. Change after trend ends. After price reaches the ultimate low, it soars, climbing 51% in a bull market and 45% in a bear market. If you can determine Table 26.2 General Statistics Description

Bull Market

Bear Market

Number of formations

640

174

Reversal (R), continuation (C)

640 R

174 R

Average decline

22%

29%

Declines over 45%

34 or 5%

23 or 13%

Change after trend ends

51%

45%

Busted pattern performance

40%a

21%a

Standard & Poor’s 500 change

1%

–13%

Days to ultimate low

62

41

Note: Minus sign means decline. a

Fewer than 30 samples.


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when the trend changes (that is, if you can find the ultimate low), then buy the stock and hold on. Busted pattern performance. I expected better from busted HSTs. First, few fail to drop less than 5% (the bear market has just one sample) before rebounding, and when they recover, the climb is less than enthusiastic. Other chart pattern types show recoveries of 60%. Standard & Poor’s 500 change. The large decline in the general market (13%) compared to the 1% rise in a bull market helps explain the excellent showing of bear market HSTs. This finding should also serve as a warning to trade with the market trend. Avoid shorting a stock showing an HST in a bull market or when the market is trending strongly upward. Days to ultimate low. It takes about 2 months for price to reach the ultimate low. Notice that the decline is farther (price) and shorter (time) in a bear market than in a bull market. Thus, the decline must be steeper in a bear market. This fact suggests shorting a stock showing an HST in a bear market for the best performance and to maximize the number of trades annually. Table 26.3 shows failure rates for HSTs. The best performance is from HSTs in a bear market as they have the lowest failure rates. For example, 1% of the patterns fails to drop more than 5%. Another example: nearly half (49%) fail to drop more than 25% in a bear market. That performance is even worse in a bull market as 68% fail to drop more than 25%. Notice how the failure rate climbs for small changes in the maximum price decline. The rate triples and then doubles as the decline moves from 5% to 15% (bull markets). The numbers should serve as a warning that as reliable as HSTs are, not all patterns perform equally well. Monitor your trade and use stops to limit your losses. Raise the stop to just above the prior minor high as price makes a new low. Table 26.3 Failure Rates Maximum Price Decline (%)

Bull Market

Bear Market

5 (breakeven)

26 or 4%

1 or 1%

10

98 or 15%

9 or 5%

15

226 or 35%

29 or 17%

20

347 or 54%

58 or 33%

25

432 or 68%

85 or 49%

30

501 or 78%

109 or 63%

35

553 or 86%

124 or 71%

50

623 or 97%

161 or 93%

75

639 or 100%

174 or 100%

Over 75

640 or 100%

174 or 100%


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Another way to use Table 26.3 is with price prediction. Suppose the measure rule (see Trading Tactics) suggests a decline to 8 from the breakout of 10. That is a 20% decline. How many HSTs in a bull market will fail to drop at least 20%? Answer: 54%. This finding suggests the measure rule prediction is unlikely to be met. Set a price target that is not so far away. Table 26.4 shows breakout- and postbreakout-related statistics. Formation end to breakout. It takes about 2 weeks for price to drop from the right shoulder peak to the breakout point, on average. Yearly position. Most HSTs reside in the middle or upper third of the yearly price range. That makes sense as HSTs are tops acting as price reversals. Avoid patterns that do not have anything to reverse, meaning that the price rise leading to the pattern is small. Yearly position, performance. The best performing HSTs occur when the breakout is in the middle of the yearly trading range. Pullbacks. Pullbacks occur between half (bull markets) and two-thirds (bear market) of the time. It takes less than 2 weeks after the breakout for prices to make the return trip back to the breakout price or neckline. When a pullback does occur, performance suffers. For example, in a bull market, HSTs with pullbacks drop 20% after the breakout. Without pullbacks, the drop measures 24%. Gaps. Performance improves with a breakout day gap only in a bear market, but the samples are few. The average gap size is unusually large, 50 cents to $1.23 wide, depending on the market conditions. Why the gap size is more

Table 26.4 Breakout and Postbreakout Statistics Description

Bull Market

Bear Market

Formation end to breakout

15 days

11 days

Percentage of breakouts occurring near the 12-month low (L), center (C), or high (H)

L13%, C41%, H46%

L18%, C48%, H33%

Percentage decline for each 12-month lookback period

L23%, C24%, H21%

L25%, C30%, H28%

Pullbacks

50%

64%

Average time to pullback ends

12 days

11 days

Average decline for patterns with pullback

20%

27%

Average decline for patterns without pullback

24%

31%

Performance with breakout day gap

–22%

–30%a

Performance without breakout day gap

–22%

–28%

Average gap size

$0.50

$1.23

Note: Minus sign means decline. a

Fewer than 30 samples.


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Heads-and-Shoulders Tops Table 26.5 Frequency Distribution of Days to Ultimate Low

Days:

7

14

21

28

35

42

49

56

63

70

>70

Bear market

22%

14%

9%

8%

6%

3%

5%

10%

2%

2%

20%

Bull market

15%

8%

9%

10%

6%

5%

6%

5%

4%

3%

28%

than twice as large in a bear market is a mystery, but gaps are nearly always larger in a bear market. Table 26.5 shows a frequency distribution of time to the ultimate low. After 1 month, 53% of the bear market patterns and 42% of the bull market patterns will have reached the ultimate low. Notice the slight uptick ending 28 and 56 days after the breakout (bull and bear markets, respectively). If your trade lasts that long, look for price to bottom out then. It may not, but it always pays to be prepared. Table 26.6 shows statistics related to pattern size. Height. Do tall patterns perform better than short ones? Yes. The widest difference is in a bear market where price drops 31% for tall patterns but just 26% for short ones. I measured height from the highest high to the lowest low in the pattern (starting from the left shoulder peak to the right shoulder peak) and then divided by the breakout price. Width. Width is less of a reliable performance indicator than height. In both markets, performance improves slightly if the pattern is narrower than the median length. Table 26.6 Size Statistics Description

Bull Market

Bear Market

Tall pattern performance

–24%

–31%

Short pattern performance

–20%

–26%

Median height as a percentage of breakout price

17.27%

20.45%

Narrow pattern performance

–23%

–29%

Wide pattern performance

–21%

–28%

Median length

49 days

42 days

Average formation length

62 days

52 days

Short and narrow performance

–22%

–28%

Short and wide performance

–17%

–23%a

Tall and wide performance

–24%

–31%

Tall and narrow performance

–26%

–31%a

Note: Minus sign means decline. a

Fewer than 30 samples.


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Average formation length. The average length of an HST appears in the table. Most patterns are about 2 months long as measured between the left and right shoulder peaks. Height and width combinations. Looking at the combinations of height and width, we find that the best performing patterns are tall and narrow, but tall and wide HSTs also perform well in a bear market. Avoid short and wide patterns. Table 26.7 shows volume statistics for HSTs. Volume trend. HSTs with a rising volume trend work well in both markets. For example, HSTs with a rising volume trend in a bull market tumbled 24% after the breakout, on average. Those with a falling volume trend dropped just 21%. Volume shapes. Of the five volume shapes I looked at, I show the three most popular ones in Table 26.7. The best performing HSTs have U-shaped volume. The random shape in a bear market includes only eight samples, so I discount the 34% decline. Breakout volume. Many analysts say that heavy breakout volume tends to push prices lower, but I have found mixed results for many chart pattern types. For HSTs, the influence of heavy breakout volume helps in both markets, but only marginally. Shoulder volume and performance. I looked at the volume for the 5 days surrounding the two shoulders and head. When volume was highest on the head, the chart pattern tended to perform better than when volume was highest on the other two shoulders. Table 26.7 Volume Statistics Description

Bull Market

Bear Market

Rising volume trend performance

–24%

–30%

Falling volume trend performance

–21%

–27%

U-shaped volume pattern performance

–24%

–30%

Dome-shaped volume pattern performance

–21%

–27%

Neither U-shaped nor dome-shaped volume pattern performance

–20%

–34%a

Heavy breakout volume performance

–22%

–29%

Light breakout volume performance

–21%

–27%

Performance when volume highest on left shoulder

–22%

–27%

Performance when volume highest on head

–23%

–30%

Performance when volume highest on right shoulder

–20%

–29%a

Note: Minus sign means decline. a

Fewer than 30 samples.


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Heads-and-Shoulders Tops Table 26.8 Miscellaneous Statistics

Description

Bull Market

Bear Market

Up-sloping necklines, performance

–23%

–29%

Horizontal necklines, performance

–24%

–33%a

Down-sloping neckline, performance

–21%

–28%

Higher left shoulder highs, performance

–25%

–30%

Higher right shoulder highs, performance

–20%

–27%

Even shoulder highs, performance

–19%

–23%a

Note: Minus sign means decline. a

Fewer than 30 samples.

Table 26.8 shows miscellaneous statistics for HSTs. Neckline slope. The best performance comes from HSTs with horizontal necklines, but the 33% decline in a bear market uses only two samples. Second to that was HSTs with up-sloping necklines. Common sense says that a down-sloping neckline would suggest an especially bearish omen because price is already showing weakness. Why HSTs with up-sloping necklines perform better is a mystery. Shoulder highs. Does a lower right shoulder predict a more bearish situation? Yes. HSTs with a higher left shoulder peak (and lower right shoulder) drop 25% after the breakout in a bull market and 30% in a bear market. When the right shoulder is higher than the left, the decline is 20% in a bull market and 27% in a bear market. HSTs with even shoulder highs perform worst.

Trading Tactics Shown in Table 26.9 are trading tactics, and Figure 26.5 shows an example of the measure rule as it applies to a head-and-shoulders top. If you ignore the backward volume pattern, the formation looks fine. Each of the three bumps appears rounded and the overall formation is symmetrical. Measure rule. The measure rule uses the formation height as a basis for computing the target price. In the head, measure vertically down from the highest daily high until you intersect the neckline. Subtract the value of the neckline from the highest high. The result gives the formation height. In the figure, the stock reaches a high price of 51 on September 13. Directly below that point is the neckline price at about 47.38. The difference of 3.62 is the formation height. Once price pierces the neckline, subtract the formation height from the daily high at the breakout point. In Figure 26.5, the high at the breakout is 48.50, leaving a target price of 44.88. Prices surpass the target when they


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Table 26.9 Trading Tactics Trading Tactic

Explanation

Measure rule

Compute the formation height by subtracting the value of the neckline from the highest high reached in the head, measured vertically. Subtract the result from the breakout price where prices pierce the up-sloping neckline, or, if the neckline slopes downward, closes below the right shoulder low. The result is the minimum target price to which prices descend. Alternatively, compute the formation height from the highest high to the daily low price in the higher of the two troughs. Subtract the result from the daily high price in the higher of the two troughs to get the target price. This method boosts the success rate and does not rely on the neckline or breakout point (useful for steep necklines).

Wait for confirmation

Play it safe: Wait for price to confirm the pattern by closing below the neckline or right shoulder low.

Short stop

For short sales, place a stop just above the lower of the two troughs or just above the neckline, whichever is higher.

Watch for pullback

Initiate a short sale or add to your position during a pullback. Wait for prices to begin falling again before placing the trade as prices sometimes pull back and continue moving up.

Arco Chemical Co. (Chemical Basic), NYSE, RCM)

– 52

Head

– 51

Right Shoulder

Left Shoulder

– 50 – 49 Neckline

– 48 – 47

Neckline Price

– 46 – 45

Target Price

– 44 – 43 – 42 – 41 – 40 Jul 94

Aug

Sep

Oct

Nov

Dec

Jan 95

Feb

– 39 Mar

Figure 26.5 The measure rule as it applies to a head-and-shoulders top. Calculate the formation height by subtracting the neckline price from the highest high, measured vertically. Subtract the result from the high at the breakout. The result is the minimum target price to which prices decline.


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decline below the value in late November. Since the target serves as a minimum price move, prices often continue moving down, as in Figure 26.5. The measure rule, as just described, is the conventional way to compute a target price. However, it does have a flaw. Consider Figure 26.6. Prices during the right trough recession decline to 27.75, well below the higher trough at 31.25. A neckline joining the two is too steep. Prices never plunge through the neckline, and it is impossible to compute a target price using the conventional method. Instead, compute the formation height by taking the difference between the highest high in the head and the lowest low in the highest trough (point A on the chart). After finding the formation height, subtract the value from point A to get the target price. In this example, the highest high is at 33.63 and the lowest low at the highest trough is 31.25, giving a height of 2.38. Subtract the result from 31.25 to get a target of 28.87. Figure 26.6 shows this value, and prices reach the target during mid-April. The alternative method has two advantages. First, it can always be calculated and is somewhat easier to use since it does not rely on the value of the neckline. Second, it is more accurate, achieving a success rate of 62%, meaning that more formations exceed the price target using this alternative method rather than the conventional one. Wait for confirmation. Returning to Table 26.9, since anything can happen, it is always a good idea to wait for confirmation before selling an exist-

Brinker International (Restaurant, NYSE, EAT) Head Left Shoulder

Right Shoulder

Target Price

A

Feb 94

Mar

Apr

May

Jun

– 35 – 34 – 33 – 32 – 31 – 30 – 29 – 28 – 27 – 26 – 25 – 24 – 23 – 22 – 21 – 20 – 19 – 18 – 17 – 16 Jul

Figure 26.6 Head-and-shoulders top with steep neckline. There is no target price using the conventional measure rule because of the steep neckline. Alternatively, compute the formation height by subtracting the higher trough low (point A) from the highest high. Subtract the result from point A to get the target price.


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ing holding or shorting a new position. In a bull market, there is a good chance price will not close below the breakout price before making a new high. Short stop. If you sell short, place your stop-loss order either just above the neckline or above the lower of the two troughs, whichever is higher. Selecting a nearby resistance point usually works well. Watch for pullback. If prices pull back to the neckline, consider adding to your short position. However, be sure to wait for prices to begin falling after a pullback. Occasionally, prices will pull back and continue rising.

Sample Trade Kelly is not just a housewife; she is much more that. When her husband brings home the bacon, she not only fries it but cleans up the mess afterward. She balances the books and keeps tabs on their newborn. She started investing years ago for fun. Now, it has become part of her daily life. In the spare moments between chores, she is often staring at the computer screen, reviewing the statistics of a prospective acquisition and letting her daughter bang on the keyboard. Over the years she has been able to parlay their meager savings into a sixfigure retirement portfolio. It was not always easy and the mistakes were painful, but she viewed each failure as a learning experience. The stock pictured in Figure 26.6 posed an interesting situation for her. She was not keen on shorting a stock because her paper trades rarely worked. Still, she kept her eyes open and searched for good investment candidates. This one piqued her interest. The stock began its uphill run just before May 1993. It followed a gently sloping trend line upward until late January when it stumbled. The stock moved down to 26.50 before recovering, a drop of less than three points, but a sign of weakness. Kelly followed the stock closely and when the head appeared, she made a note on her program that it might turn into a head-and-shoulders top. “It just had that certain feel.� She was correct. The right shoulder plunge took prices lower than she expected but quickly recovered to near the left shoulder high. She drew a neckline below the two valleys and thought the line was too steep to serve as an anchor for the measure rule, so she used the alternate measure rule and computed a target price of just 28.88. This did not seem right either, so she used the right shoulder low to compute another target. This one turned out to be 21.88, or the height from the head to the right shoulder valley projected downward from the valley low. That target would take prices back to the July 1993 level and it seemed reasonable to her. Still, something bothered her about the stock and she decided not to trade it. When the doorbell rang, she left her daughter alone briefly to answer it. Moments later, the phone rang. It was her broker confirming that the stock


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sold short. Kelly ran to the computer to see her daughter standing on the chair, beating on the keyboard with a wide but guilty grin on her face. Kelly hoped it was only gas, but, no, she had indeed sold the stock short at 31. After spending some anxious moments reviewing the trade, Kelly decided to maintain the position. The number of shorted shares was just 100, an amount she could live with. Prices quickly retreated to the neckline where they found support. The stock bounced and when it moved above the right shoulder low, she got concerned. After a few days, the stock leveled out and moved sideways. In case this turned out to be the beginning of a measured move up, she placed an order to cover her trade at 29. That would leave her with a small profit but still allow her to participate if the stock declined. Two weeks later, she had an answer. The stock tumbled for 5 days in a row, then just as quickly recovered, only this time it formed a lower high. The volatility was wearing her down so she placed an order with her broker to cover her position when prices reached the old low. She was taken out when prices descended to 22.75 on their way down to 20. After expenses, she made about 25% on the trade. Her daughter got a big kiss for her help.

For Best Performance The following list includes tips and observations to help select HSTs that perform better after the breakout. Consult the associated table for more information. • • • • • • • • • • • •

Review the identification guidelines for correct selection—Table 26.1. Select patterns in a bear market as they decline farthest—Table 26.2. HSTs in a bear market have lower failure rates—Table 26.3. Choose patterns with breakouts in the middle of the yearly price range—Table 26.4. Pullbacks hurt performance, so avoid trades with nearby underlying support—Table 26.4. Look for price to bottom in week 4 (bull market) and week 8 (bear market) after the breakout—Table 26.5. Tall or narrow patterns perform better than short or wide ones. Avoid patterns that are both short and wide—Table 26.6. Select patterns with a rising volume trend and heavy breakout volume—Table 26.7. Patterns with U-shaped volume do best—Table 26.7. Pick patterns with volume highest during formation of the head— Table 26.7. Choose patterns with horizontal or up-sloping necklines—Table 26.8. Patterns with higher left shoulder peaks perform best—Table 26.8.


Encyclopedia of Chart Patterns 26