I am going to divert my attention this week to a discussion some of the most common technical patterns. In the next several issues of The ETF Authority, I'll use this "Educational Bonus" section to cover what are commonly known as "reversal patterns." Beyond that, I will then move into a discussion of "continuation patterns."

WHAT IS A REVERSAL PATTERN?
There are common price patterns, or formations, that all traded assets and liabilities tend to trace out when they are in the process of changing their current price trend. When I mention the term "reversal pattern," I'm referring to a pattern that generally shows up during a complete change in trend direction (from rising prices to falling prices or from falling prices to rising prices).

In this week's lesson I will cover one of the most common reversal patterns around -- the "Head and Shoulders" reversal. In future lessons I will discuss Double Tops/Bottoms and Triple Tops/Bottoms, as well as saucers (cup-and-handles) and V-reversals.

THE HEAD AND SHOULDERS REVERSAL PATTERN
Two types of head and shoulders patterns exist: Head and shoulders tops and head and shoulders bottoms (these are sometimes called "inverted" head and shoulders). According to some analysts (yours truly included), head and shoulders can also be considered a valid continuation pattern. However, I will cover that topic in another lesson.

A topping pattern involves a rally to a new high, followed by a fall in price -- this forms the left shoulder. Then, prices rally to a new high yet again. This is the head. Another correction takes prices lower again. A third rally then takes place, but this time the bulls cannot manage to pull a new high out of the hat. As prices fall, the right shoulder forms. For a head and shoulders bottom, just reverse the directions in all of the aforementioned statements: an initial new low forms the left shoulder, then prices rally, followed by another lower low (head), another rally, and a third drop, but not to as low as the levels seen when the head was formed (right shoulder).

To help you visualize this basic concept, I've included a stylized drawing of a head and shoulders top below:

As you can see, I drew a line connecting the low set following the left shoulder and the fall after the head. This line is called the neckline. A neckline is not a trendline (Remember -- trendlines require three touches, yet I've drawn this line from just two points. Please see our July 21st, 2003 ETF Authority issue for more information on trendlines.) The head and shoulders pattern is not considered confirmed until prices close below the neckline.

PRICE PROJECTIONS
The classic way to measure the expected price drop following a head and shoulders top is to draw a perpendicular line from the head to the neckline. After doing so, count the distance (in per-share $ amounts) there are between those two price levels. Then, subtract that dollar figure from the price level at the time of the trendline break. This will give you the approximate downside target the shares should reach following a head and shoulders top.

There are a couple of caveats regarding this technique:

• When using this method, you can occasionally end up with negative price targets. To compensate for this, I use percentage moves as opposed to dollar amounts for all but the smallest price patterns.

• Other measurement techniques may be more accurate. Although most textbooks indicate that the head to neckline is the minimum target, in practice I have found that prices do not always reach even that projected level. One reason may be due to using arithmetic instead of percentage change projections.

(Aside: When I discuss Elliott Wave Theory in this "Educational Bonus" section, I will show you how the head and shoulders pattern fits into an Elliott Wave-based technical analysis framework.)

NECKLINE SLOPE
As you can see in the chart above, I drew a neckline with a positive (rising) slope. However, that is not a requirement. In practice, the actual neckline may sometimes be flat or downward sloping. Analysts often contradict themselves by saying that a downward=sloping neckline means that much of the move has already occurred. That cannot be true if you go by the price project method noted above. My experience shows that downward-sloping necklines are another reason to believe the classic rule is flawed. Elliott Wave-based targets should work better, where applicable.

THE PSYCHOLOGY OF A HEAD AND SHOULDERS
For simplicity's sake, I am going to continue to discuss this topic by using the head and shoulders top pattern as my example (shown above). However, the arguments can just be reversed for a head and shoulders bottom.

As prices rise into the left shoulder, the market is in great shape. All of the news is good. Everybody is happy. And, the technical analysts, fundamental analysts and the little guy as well all agree that everything is coming up roses. There are no clouds on the horizon. However, sooner or later a market must take a breather. At that point we start to see some profit taking, forming the left shoulder.

The next leg higher still sees all good news. Pretty much everybody is in agreement that the joy ride will never end. However, some technical analysts (especially those using Elliott Wave) begin to get nervous. Momentum divergences begin to show up in the chart even as prices make new highs. Still, the news remains good. Bullish observers dismiss the drop from the new high is as "just another round of profit taking." This correction forms the head.

In all likelihood, the news will still be positive as the right shoulder is formed. In fact, the failure to make a new high might even come, in the case of an individual stock, on the announcement of positive earnings news. However, the stock does not manage to achieve a new high and prices fall again. Now, people are getting nervous and you will likely see more substantial profit taking, and possibly some trendline breaks and moving average crossovers. Even though fundamental stock analysts are probably more bullish than ever, technical analysts are bearish.

Finally the neckline breaks, and all but the rose-colored-glasses types turn bearish.

THE IMPORTANCE OF VOLUME
Happily, as traders in the equity markets, we get to see volume figures throughout the day. Most futures traders do not receive volume reports until the next business day begins. And, for those playing in the over-the-counter markets, such as foreign exchange, volume data do not even exist. Without volume data it is far more difficult to identify a head-and-shoulders pattern.

In the psychology section above, I left out the volume signatures just give you a feel for what people are thinking. However, as you'll soon see, volume levels are extremely important to examine during a head and shoulders pattern.

Recall that an uptrend is typically confirmed by higher prices. You need to push prices higher (downtrends may see low volume, however, as prices can fall from the force of gravity). Therefore, as the left shoulder is formed, volume should be strong and rising. When prices turn lower in the corrective side of the shoulder, volume should dip. As prices reverse higher, volume should increase again. At the head, I would expect strong turnover, although turnover does not always exceed what it was at the left shoulder.

As we turn down from the highs, volume generally eases once again. However, I am usually more comfortable if trading activity is a bit stronger on the downside than it was as prices dipped following the left shoulder peak. As prices rise into the right shoulder, the books say volume ought to improve. My experience shows that to be iffy at best. As prices make a beeline for the neckline, turnover often increases and it is not uncommon to see a breakaway gap on high volume over the neckline.

Please be aware that the volume profile might not be exactly the same for a head and shoulders bottom. As I had noted previously, turnover may not be all that high as prices fall. However, you'll often see very high turnover at the final bottom as capitulation sets in.

HOW LONG DOES IT TAKE TO FORM A HEAD AND SHOULDERS PATTERN?
Unfortunately, a clear-cut answer to this question does not exist. The textbooks will tell you that a head and shoulders takes weeks to form, and in some cases could even take years. However, day traders will see them intraday as well, and they are just as valid then. In addition, it's not practical to try to trade a multi-year head and shoulders. Worthwhile positions can be taken off several-week to several-month formations.

AN EXAMPLE: THE S&P 500 SPDR (SPY)
As you can see from the chart below, the S&P 500 SPDR (symbol SPY) recently formed an inverted head-and-shoulders pattern that traversed ten months (from July 2002 through May 2003). The volume patterns were pretty good as well: High on the left shoulder, increasing (but not as high) on the head. I would have been happier if volume had been a bit weaker at the right shoulder, but no pattern is perfect. The low volume in November and December represented a seasonal slowdown rather than being technically driven.

Please remember that technical analysis is an art, not a science. With this in mind, I've drawn two necklines on the chart below. The top neckline (in blue below) is how most analysts would draw it -- connecting the two peaks following the left shoulder and the head. I've also drawn an alternate neckline from nearby highs instead (just beneath the other neckline). This version eliminates the problem of the neckline being breached on the downside in mid-May (area in the circle) and instead has a perfect retest to the neckline -- a fairly common occurrence.

Note that this chart suggests prices have higher to go yet, with price targets in the 113 to 118 range. However, Elliott-Wave-based analysis points more to a likely 104-108 target for SPY instead.

SUMMARY
The head and shoulders pattern is probably one of the best-known technical analysis formations. It is easy to recognize and with proper analysis should prove to be a profitable one to trade. However, when analyzing this pattern, you must remember to apply all the information at hand, including volume and sentiment. If there is not great optimism or pessimism, or if volume is not developing as would be expected, then I would be extremely careful about trading such a pattern. Also, avoid attempting to predict completion of pattern even before the right shoulder has formed. This is a common trap many traders and investors fall into.

Good trading!

Steven Poser
Editor
The ETF Authority
New York, NY

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