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Head & Shoulders Top
Chart Patterns - Reversal - Head & Shoulder 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.
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