The Head and Shoulders Reversal Pattern

Let's take a close look now at what is probably the best known and most reliable of all major reversal patterns-the head and shoulders reversal. We'll spend more time on this pattern because it is important and also to explain all the nuances involved. Most of the other reversal patterns are just variations of the head and shoulders and will not require as extensive a treatment.

This major reversal pattern, like all of the others, is just a further refinement of the concepts of trend covered. Picture a situation in a major uptrend, where a series of ascending peaks and troughs gradually begin to lose momentum. The uptrend then levels off for awhile. During this time the forces of supply and demand are in relative balance. Once this distribution phase has been completed, support levels along the bottom of the horizontal trading range are broken and a new downtrend has been established. That new downtrend now has descending peaks and troughs.

Let's see how this scenario would look on a head and shoulders top. The uptrend is proceeding as expected with no signs of a top. Volume expands on the price move into new highs, which is normal. The corrective dip is on lighter volume, which is also to be expected. However, the alert chartist might notice that the volume on the upside breakout through point is a bit lighter than on the previous rally. This change is not in itself of major importance, but a little yellow caution light goes on in the back of the analyst's head.

Prices then begin to decline and something even more disturbing happens. The decline carries below the top of the previous peak. Remember that, in an uptrend, a penetrated peak should function as support on subsequent corrections. The decline well, almost to the previous reaction low point, is another warning that something may be going wrong with the uptrend.

The market rallies again, this time on even lighter volume, and isn't able to reach the top of the previous peak point. To continue an uptrend, each high point must exceed the high point of the rally preceding it. The failure of the rally point to reach the previous peak point fulfills half of the requirement for a new downtrend-namely, descending peaks.

By this time, the major up trend line (line 1) has already been broken, constituting another danger signal. But, despite all of these warnings, all that we know at this point is that the trend has shifted from up to sideways. This might be sufficient cause to liquidate long positions, but not necessarily enough to justify new short sales.