Recommended
Encyclopedia
of Chart Patterns
staff
review of more
books like this
|
 |
Head
& Shoulders Top
Technically speaking a head and shoulder top
pattern is a rally to a new high and weakness to intermediate support, a second
rally to a higher high and decline to support, followed by a modest third rally
and decline through support.
Why Does It Happen?
Head and shoulder patterns are among the most
important of reversal patterns because they are both common and reliable.
The head and shoulder top pattern consists of three rallies and a
breakout. The reversal pattern gets its name because the middle rally
reaches the highest point while both the first and third rallies are
approximately equal in height. The left shoulder of a head and shoulders top pattern will always take shape after an extended rally
to new highs. Buyers seem willing to pay increasingly exorbitant prices
because all of the fundamental data is perceived to be improved. After one
particularly bullish report the stock surges to a new high on strong volume as
analysts pound the table with new "buy" recommendations but days later
profit taking leads to a modest reactionary pullback (reaction low).
Bullish investors and analysts rationalize that the weakness is just normal
profit taking after a lengthy advance and they are partly correct -- the selling
is profit taking but it is far from normal. On this first pullback those
investors that bought the stock at lower prices begin distributing their stock
into the good news, they have made their money and they want out. As the stock
declines buyers regroup and the torrid rally resumes. Because all of the
fundamental news remains bullish, the next rally to new highs easily exceeds the
first. The stock very quickly rallies to a fresh new high but there is just one problem, despite the
barrage of positive corporate news and Wall Street cheer, volume declines
relative to the initial rally. As the stock continues to move higher
selling by investors that purchased the stock at lower prices intensifies and it
is not long before the imbalance between buyers and sellers causes a
considerable decline. Rumors begin to swirl that institutions and insiders
are selling. Days later the stock drifts back to test the reaction low and
volume surges. This price action forms the head of the
pattern. As the stock tests its reaction lows positive news hits the tape
and buyers return. A third rally begins amidst new "buy"
recommendations from Wall Street analysts. Unfortunately, the third rally is even more
feeble than the previous two moves higher. The stock does advance but
volumes slows to a trickle and it becomes clear that the stock is being
distributed. After several more sessions the stock begins to decline yet
again and a move back to support at the reaction lows ensues. In keeping
with the imagery of the pattern, this key support level is often called the neckline of the head and shoulder top pattern. The third
decline to this level completes the right shoulder of the
pattern. As the stock approaches support for a third time positive
comments from Wall Street analysts continue but this time buyers are overwhelmed by
sellers, volume expands and the stock collapses. Weeks later the stock
trades back to longer-term support.
How are Technical
Measures and Targets Derived?
The technical target for head and shoulders top patterns
is derived by subtracting the difference between the highest level achieved in
the formation of the "head" and the level of the
"neckline" from the new breakout level.
Head and Shoulders Top for Krispy Kreme
Doughnuts
Krispy Kreme Doughnuts (KKD) came along at the correct time for frustrated
technology investors. In the late winter of 2000 investors had seen
technology share prices implode and they were looking for a non-technology something to sink their teeth into. Krispy Kreme had a very well
known and loved product and the franchise seemed like a winner. After
making a low on April 5, 2001 at $15.12 the stock soared to a high of $38.53 on
May 29. Along the way there were several Wall Street buy recommendations,
rumors about a possible merger with Starbucks (SBUX) and a stock split
announcement. All things considered, the stock seemed to be climbing the
wall of worry nicely but the May 29 high proved short-lived. By June 4 the
stock settled back to a low of $33 as some investors began to question the rich
valuation. This price action created the left shoulder. Just days
later the stock began to move higher once again. Although volume remained
subdued, continued optimism over expansion into new markets and talk about a
"global brand" sent Krispy Kreme shares to a fresh new high at $43.50
on June 19. It was about that time that the SEC filings revealed that the
firms CEO was petitioned to sell 80,000 shares of Krispy Kreme stock. The
stock immediately began to work lower. By July 11 the stock was back to
the $33 support level. This price action created the head. On July 12
Krispy Kreme stock once gain began to work higher. By July 23 the stock
was trading back at $38.38 but volume was even slower than the previous two
rallies. It seemed as though it would only be a matter of time before
price deteriorated and on July 25 the stock fell back to $33. This price
action completed the right shoulder of the pattern. Several sessions
later the stock traded back to
$26.93.
Vital Signs
-
Symmetry is important. The most
reliable head and shoulders top patterns are
symmetrical, that is the left and right shoulders take shape over the roughly
the same number of days. Patterns with extended right
shoulders should be avoided.
-
It is important that volume decline on each
successive rally in the head and shoulders top pattern. The weak
volume and rising price is a good indication that distribution is at work.
-
No pattern is truly complete until there is a
breakout close below the neckline of the pattern.
-
Downside breakouts often lead to small
2-3% declines followed by an immediate test of the breakout level. If
the stock closes above this level (now resistance) for any reason the
pattern becomes invalid.
Now that we're finished with our
anatomy lesson, let's move on to the dynamic diamond pattern.
head
and shoulders bottom 
diamond
|
|
