Head and Shoulders Top Formation

The head and shoulders top formation (H&S top) is one of the most popular and reliable chart formations used in technical analysis. As the name indicates, its shape is similar to a head with shoulders on both sides. A head and shoulders pattern usually signals changes in the price trend. When it occurs, the analyzed security is more likely to move against the previous uptrend. For instance, a head and shoulders in gold, would mean that the top in gold is likely in.

There is another formation, which works similarly to the H&S top but signals a reverse of a downward trend. It is called the inverse head and shoulders formation (reverse head and shoulders and H&S bottom are other names).

Mining Stocks and the Head and Shoulders Formation

The H&S top is characterized by two similar tops called shoulders, and one higher top called the head. The "neckline" is determined by the bottoms between the shoulders and the head. The price may go below the neckline, but if it comes back to the neckline it might rebound off it. Bellow you will find a picture presenting a head and shoulders top formation.

Charts courtesy of http://stockcharts.com/

This pattern tends to form at the top of an uptrend and is considered a trend reversal pattern, because the price continues to fall after the formation’s completion.

There are four steps for this formation to be completed. When they are achieved, the pattern signals a reversal in trend.

1. The first step is the forming of the left shoulder. It occurs when the price of an asset reaches a new top and retraces afterwards (in our mining stocks example the left shoulder was completed in mid-March).
2. The second step is the forming of the head. This happens when a new top is established (higher than the previous left shoulder top) and the price comes back to the level near the left shoulder bottom (in the above chart such a pattern may be noticed between mid-March and mid-May).
3. The third step is the forming of the right shoulder. Another local top is formed, lower than the previous one (lower than the head) and near the level of the left shoulder top. Once again, it is followed by a slump (first days of June).
4. The fourth step completes the whole pattern. The price falls below the neckline, which is a support level established by the lows between the head and the shoulders (mid-June).

After the completion of this formation there is a reasonable probability that price will continue falling even if it rebounds for a while. A short period of growth would probably be followed by a retracement to the neckline and by further declines. A small increase in price after the apparent completion of an H&S pattern would be a verification of the whole pattern if the price doesn’t move above the neck level.

However, it is essential to wait and verify the pattern as the main move will most likely occur after the verification.

You should always remember that the head and shoulders pattern is not always validated. If a significant move up on high volume takes place during the verification phase, the whole pattern might be invalidated. This was ultimately the case in the example from our previous chart.

Head and Shoulders Gold Tops and Volume

Volume plays a significant role in the confirmation of a trend and this is particularly the case with gold and the rest of the precious metals market. In the head and shoulders top formation it is important to have the price decline below the neckline confirmed by high volume. Significant volume signals that there are a lot of sellers in the market, which means that supply and demand are moving in the directions our formation suggests. Volume may be used as a secondary indicator, to gauge the formation’s strength.

Speaking of volume, please note that in our example volume was declining during rallies and rising during price declines, and thus the formation was quite reliable. Moreover, from early June on, all daily counter-trend rallies were seen on low volume levels, whereas declines were accompanied by high volume. This was a bearish sign.

The neckline, based on both the daily closing prices and the intraday lows, was broken. The breakdown took place on significant volume and the preceding rally had been accompanied by low volume. This was a very bearish combination. Remember that if we see a move higher up to the neck levels, and this move takes place on low volume, then it most likely serves as a verification (and not invalidation) of the breakdown.

Please remember, that without confirmation coming from volume (high volume when the neckline is broken) the H&S top formation is less reliable. So, if available, you should always check volume for a confirmation of this formation if you want to take any action based on it.

A few more remarks on the relationship between volume and the H&S top formation (these are more tips than rules):

• The left shoulder top should be formed on high volume.
• The left shoulder bottom (between the left shoulder peak and the head) should be accompanied by low volume.
• The head should be formed on high volume, but not as high as in the left shoulder top.
• The right shoulder top should be formed on lower volume than both the left shoulder top and the head.

Precious Metals Declines and the Target Price

Another very useful feature of this formation is that it allows us to calculate a target price for the decline. This will be discussed using the chart below.

You can easily see that the head and shoulders formation was completed. The price tested the neckline (the resistance level), and declined afterwards. Now, imagine that we are in that precise moment when the price broke down below the neckline. Since we already know the price direction (from the confirmed pattern), we can now forecast how big that move will be. To do that, we might use the target price. This is a measure of where the price is considered to be headed, based on the confirmed pattern. Take a look at the chart above. The target price is marked in the range of 275 to 300. How did we get these numbers?

In the simplified method, the target price is calculated by subtracting the difference between the head level and the neckline level from the neckline level. In this case that would be: 390 (the neckline level) - 140 (520 - 380, the difference between the head and the neckline) = 250 (target price or price objective). You may notice that 250 is slightly different from the target level of 275 to 300 marked on the chart and mentioned before. Why is that? The explanation is that in the chart we used a logarithmic scale (not the linear one). The logarithmic scale is better for substantial moves and that is the case in the above chart. Because of that, we need to use a different method.

This alternative method calculates the range in relative terms. The first step is to calculate the distance between the neckline and the head (in relative terms). Then we apply this distance to the end of the neckline. Here, we have 380 / 520 = 0.73 and 390 * 0.73 = 284.7. This value is consistent with our range of 275 to 300.

We do not consider the target price an extremely precise prediction but rather an indication of how strong the price decline might be (that is why we would prefer to assume that the target price is in the range of 275 to 300 rather than at the level of 280). The rule is quite simple here: the greater the distance between the head and the neckline, the lower the price is headed.

To sum up, the head and shoulders top formation is quite common in technical analysis and it can be seen every now and then on the gold market. However, you have to be careful and wait for a confirmation of this formation by a move lower on high volume or wait for verification (a small rally back to the neckline).