Discussion 12 : Head and Shoulders

Greetings! Made any profits last week? = )


INTRODUCTION
Head and Shoulders (H&S) is a chart pattern which is extremely reliable in identifying an end of an uptrend and gives birth to a new downtrend, and is very commonly seen on daily charts, as well as intra-day charts. The silhouette of H&S pattern resembles a human with one head and two shoulders.

The reverse of this chart pattern is known as Inverted Head and Shoulder Pattern (IH&S), which I regard as rather rare in KLSE, and is comparatively less reliable than H&S. IH&S is a bullish reversal chart pattern which is seen at the bottom of a downtrend.

The heart of Discussion 12 is H&S, which is a bearish reversal chart pattern.

CHART PATTERN OF HEAD AND SHOULDERS
H&S is basically identified by its pattern of having three consecutive tops, with the middle top higher than the tops on the left and right side. A neckline is drawn from the low of the retracement of the left top, to the low of the retracement of the middle top, projecting it further to gauge the retracement low of the right top. Refer illustration (i).

Illustration (i) : KNM - H&S and Neckline

BREAKING THE NECKLINE
The H&S pattern is complete when the price breaks the neckline on the right. Then, the stock price would have effectively fallen out of the prevalent trend. If the neckline at the right shoulder is not broken, then there is a possibility of it being a false signal. The high of the right shoulder should not be broken if the signal is to remain valid. After breaking the neckline, the neckline support now turns into neckline resistance. Refer illustration (ii).

Illustration (ii) : KNM - Breaking the Neckline

PREDICTIVE NATURE OF HEAD AND SHOULDERS PATTERN
The distance between the head and neckline would be taken as a guideline to gauge how far will the price drop after breaking the neckline. There is a rather complicated rationale behind this technique, which I would not explain further as at now. Having said so, I find that the gauge is rather accurate when practised in KLSE. Refer illustration (iii).

Illustration (iii) : KNM - Predictive Nature of H&S

THE ROLE OF VOLUME IN HEAD AND SHOULDERS PATTERN
Ideally, we would want to see higher volume on the build-up of the left shoulder (preferably a volume blowoff at the left shoulder top) compared to the build-up of the head. This means there are declining interests in the build-up towards the top of the head. The descent from the top of the right shoulder that breaks the neckline should be accompanied by increasing volume. Refer illustration (iv).

Illustration (iv) : KNM - Volume in H&S

OTHER CONFIRMATIONS
It is crucial that any TA techniques not to be used in isolation. Traders/technicians must seek confirmation(s) or convergence(s)/divergence(s) of other technical indicators to further enhance the signal emitted by any one indicator.

In explaining the the above theories, I have made use of KNM as an illustrative example. Keep in mind that you might have already seen this chart in Discussion 11 (Part 1) : Playing the Gap (Basic Hand). Aside from Gap Analysis and H&S Pattern, many other indicators can be used to further confirm this signal. For instance, Volume Analysis (as detailed above), Stochastic Divergence, and Moving Average. Refer illustration (v).

Illustration (v) : KNM - Stochastic Divergence / Moving Average Convergence

ANOTHER EXAMPLE
Please see the below chart for another illustration of H&S Pattern in WCT (illustration (vi)).

Illustration (vi) : WCT - Head and Shoulders Pattern

CONCLUSION
With the recent KLCI moving upwards after a few successive declines, it is imperative to deduce that the index is currently in a downward momentum. With this upward movement seen as a temporary pullback (in my opinion), I would be expecting to see more downward movements in the near future, and I mean real near future. >.<

I hope that by sharing this bearish reversal chart pattern would help serve my readers to as an early indication of any possible trend reversals that might unfold. Capital preservation is number one priority in stock trading. Therefore, remember,

"Cut your losses short, let your profits run!"

Happy trading for the coming week ahead~!   = )