Head and Shoulders Technical Formation

This is the best-known and most widely used reversal pattern. It is easy to spot and follow, and generally, its signals are reliable. The Head & Shoulders (H&S) chart pattern (See the chart of Merck, NYSE: MRK) resembles the real thing: three successive rallies consisting of a Left Shoulder, a Head and a Right Shoulder. In between are dips. The end of a major uptrend comes when the chart of the right figure fails to reach the height of the center and heads downward. A head-and-shoulders formation occurs at the end of a long rise in the price of a stock. What happens is this: The development of the Left Shoulder (1) represents an upturn of some duration. The climax is reached with a strong rally. As the price of the stock goes up, the level of buyer interest tends to increase. More and more buyers place their orders to buy and thus drive the price up with higher volume than usual. At this top (2), the people who bought during the uptrend start to sell. This creates an oversupply and the price of the stock drops-the first valley (3). Near the base of this technical reaction, people who missed the first uptrend start to buy at relatively low prices. This creates a rally, which pushes the stock up again to form the Head (4). The formation of the head is usually accompanied by an increase in trading volume. This second formation (The Head) marks a new high and usually lasts for a longer period than either shoulder. Finally, when most buyers have obtained their shares and only a few buyers are left who are willing to buy at the high current price, they become outnumbered by the sellers (at the top of the head). The supply of stock available at these prices exceeds the buyers' interests and prices are driven down (to form the right side of the head). The sellers take charge again and push the price down so that most of the first move gain is erased. The bottom comes at or slightly below the previous valley (5). Normally, this volume is not as great as in the first Left Shoulder buildup/downswing. The decline from the top of the head must proceed to a level below the top of the left shoulder before it turns up to form the right shoulder (5). The Right Shoulder is the third rally and peaks at a lower price than the Head and at about the same height as the first formation. Volume may sporadically but, overall, will be less than those of the earlier patterns. The Right Shoulder development is the last chance for eager buyers. After the price has declined for the second time (completing the Left Shoulder and the Head), more buyers decide to buy and they begin to drive the price up to form the right shoulder. As the price approaches the previous high, current holders of the stock, fearful that the price may not return to its previous high, become anxious to sell their shares and are willing to accept prices lower than the preceding peak. The drop comes when early buyers start to get out at a profit or, more likely, at a break-even point. The neckline can then be drawn across the bottom points of the two valleys between the three peaks (the blue line near $69 level). A sell signal is given when the neckline is penetrated to the downside by a distance of 5-10 percent of the price at that point. To the technician, no H&S is complete until this down break occurs. If the final down move is followed by lower volume, there may be a pullback. Thus, it is possible the price could come back over the neckline. This gives holders on a last chance to get out with little or no loss. This is short a technical rally which will stop at 5-10 percent over the neckline (6). But from then on, the decline starts (7). This is the point when all investors turn themselves to sellers, anxious to bail out. The final penetration of the neckline is devastating to the stock - there is a good chance that the price of the stock will go into a long-term decline. Please, don't forget that good fundamental news could turn the stock around at some point, and you will see a reverse on the stock price.