No, I’m not referring to the dandruff shampoo. Instead, I’m referring to one of the more dubious patterns in technical analysis. Head and shoulders refers to a pattern of price action that can be seen on a chart. It comes from one facet of technical analysis, that of chart patterns.
I’ve always considered the head and shoulders pattern to be a bit goofy . . . until today, when Jason Goepfert of sentimenTrader sent out a piece on it. I’ve mentioned the sentimenTrader service in the past. He focuses almost exclusively on investment sentiment, but occasionally strays into other aspects of technical analysis. What he does well is look at past occurrences of a pattern or observation, like the recently-cited “Golden Cross,” and see how the market action played out afterward.
First, here’s what a head and shoulders (H&S) looks like. The security’s/index’s price traces out three peaks with bottoms forming a trendline, called the neckline, as shown. Furthermore, it’s possible to measure a downside target once the trendline has been violated (triggered). To get the measured move, one takes the distance from the trendline to the peak of the head and projects that onto the violation point. Up until the trigger/violation, it’s merely a H&S setup.
Jason at sentimenTrader found that, over the last 15 years, there have been 1,322 H&S set ups in the S &P 500 where the two shoulders and the head have formed. The trigger occurs when the market closed below the–yellow above, red below–trendline. Further, he found that 870, or 65%, violated the trendline, or triggered the H&S. Most surprising, he found that 87% of the those reached the measured move target.
Notice that the neckline was formed after the left shoulder. The lower wicks of the candle touched it three times. (In drawing trendlines, the first two touches establish the trendline; the third and later confirm it.) The measured move from the peak of the head is 70.32 points. 892.08 is the present trendline level. Today, the market opened at 894.27, got as low as 886.36, and closed at 898.72. For the sake of your and my 401(k)s we need to trendline to remain unbroken, as the measured move would target 822, and that point gets reached in 87% of the violations/triggers. We’ll consider the trendline broken when the index closes below it. I’ll alert you when that happens.