Trader’s Narrative

A ‘head and shoulder’ formation is one of the most famous technical formations in price charts, probably because it is one of the most common formations. The name comes from the way that the chart formation looks like the sillouette of a person’s upper torso.

The head and shoulder formation consists of a rally (the head) separated by two smaller rallies (the shoulders), preceding and following it. As with all technical formations, the fractal nature allows for it to occur on a variety of time lines, from minute charts to weekly and monthly charts.

The slope of the neckline can also vary, being horizontal, downward or upward sloping. In all cases, the effect is the same. Upon completion, the expectation is for lower prices:

Volume is also an integral part of this pattern. Typically volume is heaviest during the left shoulder, or first tentative rally. Then during the more successful rally that follows (head), volume recedes. And the final, smaller rally has equal or lower volume. As you can see from the chart of the S&P 500, the head and formation that has printed recently follows these volume conventions exactly.

If the Head and Shoulder formation completes, then the target would be 820 for the S&P 500 Index (SPX). I got that by taking 885 as the neckline and 950 as the top of the ‘head’ and then projecting the difference downward. Depending on how you drew the line you may have gotten a slightly different number but I’m sure it would cluster around the same level.

Although instantly recognizable to the trained human eye, this chart formation is extremely challenging to quantify. But there have been more than a few who have taken a crack at it. Over the years I’ve read a handful of research reports that show the results are surprisingly positive. Even those who are skeptical of the efficacy of technical analysis in general, have accepted that a head and shoulder formation is very reliable.

Interestingly, this technical pattern is printing not only in the important Standard & Poors 500 but in the Russell 2000 (small caps) and the Dow Jones Industrial. But not in the Nasdaq Composite as the tech sector’s high relative strength has powered this index to higher highs. On the other hand, you could argue for a double top pattern in the Nasdaq which is equally bearish.

The important thing right now is to watch for the completion of the head and shoulders pattern. If it breaks the neckline, then the projection stands. However, such a formation is not guaranteed to complete. If we have a head and shoulder failure - that is prices break the neckline but do not go lower, then usually what follows is an explosive rally as many people who expected lower prices are caught on the wrong side and have to cut their losses.

Head and shoulder formations are one of the most fundamental technical patterns. They are arguably one of the easiest to recognize on a chart and are almost always found at turning points in price. Right now we are seeing the S&P 500 Index (SPX) carving out what looks to be the right side of a head and shoulder formation:

The defining element of this patterns is not only the striking silhouette it leaves behind on price charts but also the volume that accompanies it. For downtrending reversals, like this one, we want to see heavy volume come in as the right shoulder is created. Ideally, a burst of activity both in price expansion and volume cements the pattern as it decisively breaks through the neckline.

Volume
It remains to be seen how this will play out. But if prices do continue to firm up, we may see this classic pattern play out. If it does, watch for the corresponding volume. You have to be careful to not read too much into the sudden volume collapse at the turn of the year since that is normal.

Neckline
The slope of the neckline is clearly downward, which is normal for an inverse
head and shoulder pattern. Anything from horizontal to downward is fine for such a neckline. An upward sloping one however, would be a bad sign.

Reversal or Continuation
Although most people categorize head and shoulder formations as reversal patterns, it is possible for them to be continuation patterns as well. There is a key difference.

The current pattern developing in the S&P 500 chart above, however it resolves, can not be a head and shoulder continuation pattern because in a downtrend, this would have to take the shape of a head and shoulder top (not bottom).

In other words it would have to look like an M not a W in shape. The other difference is in the required volume pattern. Instead of it showing more volume on the left shoulder and head and less on the right shoulder, a continuation H&S pattern will show diminished volume on the three points.

Meltingpot
The prevailing sentiment is too optimistic right now, which from a contrarian point of view makes it less likely to make this a lasting bottom. But sentiment is just one aspect of the market. There is also technical and fundamental. And some would say fund flows.

So this potential head and shoulder formation is just one more aspect of this crazy market that we have to consider and throw into the pot.