Forex Trend Reversal: The Head-and-Shoulders and the Inverted Head-and-Shoulders Patterns

There are different reversal patterns that can be used in forex technical analysis. This article considers two of them - the Head-And-Shoulders and the Inverted Head-And-Shoulders.

Head-And-Shoulders Trend Reversal Pattern

The head-and-shoulders pattern is one of the most reliable and popular trend reversal patterns that can be observed on charts. This chart formation includes three successive rallies and depicts the following currency price movement:

The currency price rises to a peak and then declines.
The price rises again, this time above the previous peak, and then declines again.
The price rises for a third time, this time below the second peak, and then declines again.

The shoulders are represented by the first and the third peaks, which are of an about equal height. The head is represented by the middle peak, which is the highest of the three. The neckline is the support line on which all of the three rallies are based. The head-and-shoulders pattern is considered confirmed and complete when the price falls below the neckline after the second shoulder.

In order that the head-and-shoulders formation successfully develops, the neckline should be broken under the conditions of a heavy market volume. As a sign for a false breakout a breakout occurring on a light volume is considered. This will cause an adverse reaction in the price of the currency.

What does a classic head and shoulders top look like?

As depicted below, the classic head and shoulders top looks like a human head with shoulders on either side of the head. A perfect example of the pattern has three sharp high points, created by three successive rallies in the price of the stock.

The first point - the left shoulder - occurs as the price of the stock in a rising market hits a high and then falls back. The second point - the head - happens when prices rise to an even higher high and then fall back again. The third point - the right shoulder - occurs when prices rise again but don't hit the high of the head. Prices then fall back again once they have hit the high of the right shoulder. The shoulders are definitely lower than the head and, in a classic formation, are often roughly equal to one another.

A key element of the pattern is the neckline. The neckline is formed by drawing a line connecting two low price points of the formation. The first low point occurs at the end of the left shoulder and the beginning of the uptrend to the head. The second marks the end of the head and the beginning of the upturn to the right shoulder. The neckline can be horizontal or it can slope up or down. However, as Elaine Yager, Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors points out, a Head and Shoulders Top neckline that is sloping downwards is highly unusual and demonstrates extreme weakness.

The pattern is complete when the support provided by the neckline is "broken." This occurs when the price of the stock, falling from the high point of the right shoulder, moves below the neckline. Technical analysts will often say that the pattern is not confirmed until the price closes below the neckline - it is not enough for it to trade below the neckline.

A classic head and shoulders top has been described above. There are many variations, some of which are described here and can be just as valid as the classic formation. Other factors - including volume and the quality of the breakout - should be considered in conjunction with the pattern itself.

Is volume important in a head and shoulders top?
Volume is extremely important for this pattern.
For a head and shoulders top the volume pattern is as follows.

Volume is highest when the left shoulder is forming. In fact, volume is often expanding as the uptrend continues and more and more buyers want to get in.
Volume is lowest on the right shoulder as investors see a reversal happening. Experts say low volume levels on the right shoulder are a strong sign of a reversal.
In the head portion of the price pattern, volume falls somewhere between the strength of the left shoulder and weakness of the right shoulder. Volume often increases when the neckline is broken as the reversal is now complete and downside pressure begins in earnest. In fact, Yager notes that one of the key characteristics she looks for in a Head and Shoulders Top is very high volume on the breakout.

Although volume is important, experts warn us not to get caught up in the precise number of shares being traded.What we're looking for are changes in the rate of trading.

What are the details that I should pay attention to in the head and shoulders top?
There are certain characteristics that experts like to see in the pattern.

1. Symmetry - The right and left shoulders should peak at approximately the same price level. In addition, the shoulders are often about the same distance from the head. In other words, there should be about the same amount of time between the development of the top of the left shoulder and the head as between the head and the top of the right shoulder. In the real world, the formation will seldom be perfectly symmetrical. Sometimes one shoulder will be higher than the other or take more time to develop. Experts warn, however, that if a shoulder reaches the level of the head, you're no longer looking at a head and shoulders top.

2. Volume - The importance of volume has already been discussed. In summary, volume should be highest on the left shoulder, lowest on the right shoulder and somewhere in between on the head. The real tip-off in this formation occurs when activity fails to rally on the right shoulder.

3. Duration of the Pattern - Some experts say that an average pattern takes at least three months from start to the breakout point when the neckline is broken. It is not uncommon, however, for a pattern to last up to six months. The duration of the pattern is sometimes called the "width" of the pattern.

4. Need for an Uptrend - This is a reversal pattern which marks the transition from an uptrend in prices to a downtrend. This means that the formation always begins during an uptrend of stock prices. Yager goes further to say that she only considers a Head and Shoulders Top pattern significant if the trend has been in existence for more than a year.

5. Slope of the Neckline - The neckline can slope up or down. The direction of the slope tends to predict the severity of the price decline. An upward sloping neckline is considered to be more bullish than a downward sloping one, which indicates a weaker situation with more drastic price declines. However, as noted above it is rather rare to have a downward sloping neckline for this pattern.

6. Decisive Neckline Break - To be complete, the neckline must be decisively broken. If the support at the neckline holds - if price bounces around the neckline or fails to move below the neckline - this is a sign that the reversal pattern has failed. If the pattern fails to decisively break through the neckline, prices will often move higher as the rally continues. Experts advise "beware a complicated right shoulder," where prices bounce around without decisively breaking through the neckline.

How can I trade this pattern?

Begin by computing the target price. The measuring technique is as follows. Begin by computing the height of the pattern. To do this, measure the number of points vertically down from the top of the head to the neckline. Subtract this number from the point where the price finally breaks the neckline, marking the end of the right shoulder. The difference is the minimum target price.

For example, assume the top of the head is 140 and the neckline vertically under it is 110. The height of the pattern is 30 (140 - 110 = 30). Assume the neckline was broken at 80. That means the downside objective is projected at 50 (80 - 30 = 50). This target price of 50 is only a guide, affected by a variety of the other factors already mentioned. Experts remind us that this target is a minimum target.Prices will often move beyond that objective.

The way you trade this pattern will depend on how aggressive you are. No matter what your personality type, however, your trading focus will be on "breaking the neck." The pattern is not complete until the neckline is conclusively broken by the right shoulder.

On the aggressive end, Bulkowski suggests that, if you are confident that a head and shoulders formation is shaping up validly, that you should sell your stock or sell short once the right shoulder forms. He believes that because his statistics show that the pattern has a 93% success rate, there's no need to wait for a confirmed breakout before entering the trading arena.

Others are less aggressive. Murphy, for example, places strong emphasis on ensuring that the pattern is complete. This can be seen by a significant breaking of the neckline, which he refers to as a "decisive closing violation" of the neckline.He argues that until that violation takes place, it's always possible that the pattern is not a head and shoulders top and that the downtrend may never take place.

Murphy advises keeping a close eye on the "return move." Sometimes, after the neckline is broken on the right shoulder, the pattern bounces back up to the neckline. This is called a return move. The return move, if it occurs at all, is often only a minor and short-lived bounce. If the neckline is broken on heavy volume, this diminishes the possibility that there will even by a return move. However, don't discount the bounce. If the price keeps hovering around the neckline without a decisive break, it may not be a head and shoulders reversal and the uptrend may resume.

Edwards and Magee call a close below the neckline break of approximately 3% of the price of the stock the "breakout" or "confirmation" of the head and shoulders top.The authors warn that up to 20% of head and shoulders tops are "saved," where prices keep bouncing around the low point of the right shoulder, before they eventually head back up.

According to Murphy, there are two tests that can be applied to determine whether the pattern is complete. He applies the 1 to 3% penetration criterion (see Edwards and Magee above) and confirms the neckline break with the "two-day rule," the requirement of the two successive closes below the neckline.

Are there variations in the pattern that I should know about?

There are a few notable variations.

Watch for the Drooping Shoulder

According to Schabacker, the drooping shoulder - where neckline has a downward slope - can often indicate a rapidly developing technical weakness. The droop happens because the stock price at the end of the head and the beginning of the right shoulder have dropped even lower than the previous low at the end of the left shoulder and the beginning of the head. Most experts agree that a downward slope has bearish implications for market weakness. Typically when the right shoulder is drooping, the trader will have to wait longer than usual for a decisive neck break. Murphy points out that when that decisive break does occur much of the move will have already occurred.

Varying Width of Shoulders

The classic head and shoulders top is symmetrical. However, if the shoulders don't match in width, don't discount the pattern. According to Schabacker, it's common for one shoulder to take longer to form than the other.If the pattern decisively breaks the neckline, it's still a valid head and shoulders top.

Flat Shoulders

While the classic head and shoulders top is made up of three sharp upward points, these need not be present for the pattern to be valid. Sometimes, shoulders can be rounded.

Multiple Head and Shoulders Patterns

Many valid head and shoulders patterns are not as well defined as the classical head with a shoulder on either side. "Complex" formations can have more variations than the classical formation. It is not uncommon to see more than two shoulders and more than one head. Edwards and Magee advise that any combination is possible, but a multiple head and shoulders is seen more often in a head and shoulders bottom rather than a top. A common version of a multiple head and shoulders pattern includes two left shoulders of more or less equal size, one head, and then two right shoulders that mimic the size and shape of the left shoulders.

Inverted Head-And-Shoulders Trend Reversal Pattern

A mirror image of the head-and-shoulders formation is the inverted head-and-shoulders pattern. This means that the same characteristics as well as potential drawbacks and signals can be referred to this type of chart formation.
The pattern includes three successive lows and depicts the following currency price movement:

The currency price falls to a low and then rallies.
The price falls again, this time below the previous low, and then rallies again.
The price falls for a third time, this time above the second low, and then it rallies again.

The inverted head-and-shoulders reversal pattern is considered complete when the price rises above the neckline.

What does a classic head and shoulders bottom look like?
As shown below, the head and shoulders bottom, also referred to as an inverse head and shoulders, looks like a top, except reversed. A perfect example of the head and shoulders bottom has three sharp low points created by three successive reactions in the price of the stock. It is essential that this pattern form following a prior major downtrend in a stock's price.

The first point,- the left shoulder, -occurs as the price of the stock in a falling market hits a new low and then rises in a minor recovery. The second point, -the head, happens when prices fall from the high of the left shoulder to an even lower level and then rise again. The third point, -the right shoulder, -occurs when prices fall again but don't hit the low of the head. Prices then rise again once they have hit the low of the right shoulder. The lows of the shoulders are definitely higher than that of the head and, in a classic formation, are often roughly equal to one another.

The neckline is a key element of this pattern. The neckline is formed by drawing a line connecting two high price points of the formation. The first high point occurs at the end of the left shoulder and beginning of the downtrend to the head. The second marks the end of the head and the beginning of the downturn to the right shoulder. The neckline usually points down in a head and shoulders bottom, but on rare occasions can slope up.

The pattern is complete when the resistance marked by the neckline is "broken." This occurs when the price of the stock, rising from the low point of the right shoulder moves up through the neckline. Many technical analysts only consider the neckline "broken" if the stock closes above the neckline.

Is volume important in a head and shoulders bottom?
It is crucial for an investor to monitor the volume pattern to determine if what looks like a forming head and shoulders bottom will prove dependable.

The volume sequence should progress in a fairly predictable way, beginning with relatively heavy volume as prices descend to form the low point of the left shoulder. Once again, volume spikes as the stock hits a new low to form the point of the head. It is possible that volume at the head may be slightly lower than at the left shoulder. When the right shoulder is forming, however, volume should be markedly lighter as the price of the stock once again moves lower.
It is most important to watch volume at the point where the neckline is broken. For a true reversal, experts agree that heavy volume is essential. Murphy advises looking for a "sharp burst" of trading volume. This increase in volume marks an increase in demand at higher prices. Buyers have entered the market in greater numbers.

What are the details that I should pay attention to in the head and shoulders bottom?
There are certain characteristics that experts like to see in the pattern.

1. Symmetry - In a classic head and shoulders bottom, the left and right shoulders hit their relative low points at approximately the same price and level. In addition, the shoulders are usually about the same distance from the head. Experts like to see symmetry but variations are not lethal to the validity of the pattern. Bulkowski comments that wide variations between the shoulders (they can vary in height or width) are common in the pattern. The head, however, is noticeably symmetrical. If a shoulder hits the low point marked by the top of the head, the pattern is not a head and shoulders bottom.

2. Volume - As mentioned earlier, it is critical to watch the volume sequence as this pattern develops.

Volume will usually be highest on the left shoulder and lowest on the right.
Investors, looking to ensure that volume increases in the direction of the trend, should ensure that a "burst" in volume occurs at the time the neckline is broken.
Experts, including Murphy, maintain that the volume pick-up at the end of the pattern is essential. "If the volume pattern does not show a significant increase during the upside price breakout, the entire pattern should be questioned." Other experts, including Bulkowski, are not so convinced: "a low volume breakout is not an indicator of an impending failure."

3. Duration of Pattern - A bottoming pattern is usually longer in duration and less volatile than a top. In addition, price swings are more marked in tops than in bottoms. According to Edwards and Magee, bottoms tend to be longer and flatter than tops. It is not unusual for a head and shoulders bottom to take several months to develop. Schabacker explains that volume activity in stocks is characteristically less after a period of declining prices than after a bull market. Because of this lower volume, patterns take longer to form and tend to be smaller than tops.

4. Need for a Downtrend - This is a reversal pattern which marks the transition from a downtrend to an uptrend. According to Yager, the formation always begins during a major downtrend in the stock's price.

5. Slope of the Neckline - In a well-formed pattern, the slope will not be too steep, but don't automatically discount a formation with a steep neckline.Some experts believe an upward sloping neckline is more bullish than a downward sloping one. Others say slope has little to do with the stock's degree of bullishness.The slope of a neckline can be too steep however. Bulkowski recommends that if a neckline is too steep, an investor should consider the highest rise between the shoulders as the breakout level, rather than the piercing of the neckline.

6. Decisive Neckline Break - As mentioned earlier, the pattern is not complete until the neckline is broken and the breakout or confirmation must occur with a convincing burst of trading activity.

How can I trade this pattern?
Begin by computing the target price. Compute the height of the pattern by measuring the number of points vertically up from the bottom of the head to the neckline. Add this number to the point where prices finally break the neckline, marking the end of the right shoulder. The sum is the minimum price target.

For example, assume the bottom of the head is 110 and the neckline vertically above it is 140. The height of the pattern is 30 (140 - 110 = 30). Assume the neckline was broken at 130. That means the upside objective is projected at 160 (130 + 30 = 160). This target price of 160 is only a guide and can be affected by a variety of other factors already mentioned. Because this projected price is a minimum target, prices will often move beyond that objective.

Yager uses two measurements, one to confirm the formation of the pattern and one to compute a target price. As in the calculation above, compute the height of the pattern by measuring the number of points vertically up from the bottom of the head to the neckline. Take the height and add it to the price which marks the bottom of the right shoulder. This calculation should be done only when the price has penetrated the neckline. The pattern is confirmed when this price target is reached.
Then take the height and add it to the neckline marking the end of the right shoulder. This second measurement is the price objective.

For example, assume the bottom of the head is 110 and the neckline vertically above it is 140. The height of the pattern is 30 (140 - 110 = 30). Assume the bottom of the right shoulder is 120 and the neckline was broken at 130. The confirmation point is therefore 150 (120 + 30 = 150) and the upside objective is projected at 160 (130 + 30 = 160). Bulkowski suggests modifying this calculation method in situations where the neckline is particularly steep and up-sloping. "Substitute the rise between the head and right shoulder (that is the highest price in the rise) for the neckline breakout price."

Bulkowski's advice is in keeping with his aggressive approach to trading a head and shoulders bottom.
According to Bulkowski, "if you can determine that a head and shoulders formation is completing, consider buying the stock. The formation rarely disappoints and the rise is worth betting on."He does continue, however, to caution potential investors to first be sure that what they are looking at is a true head and shoulders bottom. If you're unsure, he advises, wait for the breakout at the neckline.

Schabacker advises patience when monitoring the development of this pattern. He bases this on the fact that a head and shoulders bottom tends to take longer to form and is smaller in size to a head and shoulders top. Don't expect the time frames for pattern development to mimic that of the head and shoulders top. Murphy suggests the investor use this difference to his or her advantage. Because of the smaller price ranges and slower development time, "it is usually easier and less costly to identify and trade bottoms than to catch market tops." Although, he concludes, because prices tend to decline faster than they go up, an investor can reap greater rewards trading a head and shoulders top. This greater reward is accompanied by greater risk.

Murphy is adamant that increasing volume is a critical confirming pattern in the completion of a head and shoulders bottom. "If the volume pattern does not show a significant increase during the upside price breakout, the entire pattern should be questioned."

Bulkowski advises investors that if they miss the upside breakout, they should wait and watch. They may not have lost a trading opportunity. "Half the time, the stock will throw back to the neckline. Once it does, buy the stock or add to your position."

Edwards and Magee call a close above the neckline break of approximately 3% of the stock's market price the "breakout" or "confirmation" of the head and shoulders bottom.

Are there variations in the pattern I should know about?

There are a few notable variations:

Multiple Head and Shoulders Patterns

Many valid head and shoulders patterns are not as well defined as the classical head with a shoulder on either side. "Complex" formations can have more variations than the classical formation. It is not uncommon to see more than two shoulders and more than one head. Edwards and Magee advise that any combination is possible, but it's more common to see multiple head and shoulders with a bottom rather than a top.

A common version of a multiple head and shoulders pattern includes two left shoulders of more or less equal size, one head, and then two right shoulders that mimic the size and shape of the left shoulders.

Flat Shoulders

The classic head and shoulders pattern is made up of three sharply pointed components - the head and two shoulders. This is not always the case. Sometimes, the shoulders can lack sharp low points and instead be quite rounded. This does not affect the validity of the pattern. "The point to note," explains Schabacker, "is simply that the stock is trying to continue its previous main movement but is restrained from doing so on successive occasions by the development of technical power or pressure in the opposite direction

source : www.recognia.com