What is a ‘head and shoulders’ pattern?

I have been asked to expand a little on the chart formation known as the 'Head and Shoulders' (H&S). Most traders will have heard of this pattern, but they may not be aware that the concept can be employed in a modified form in short-term trading. So today I'd like to show you how I use it in my trading.

No self-respecting chartist of my era would dream of not searching for H&S patterns at the suspected end of a major bull or bear trend. Below is an example of what a good one looks like and it's a real corker!

The chart shows the daily Dow in 2008-2009. It shows the huge bear market starting at the all-time high at over 14,000 to the 6,500 low made in March 2009. From the rally high in early November, the market then plunged to make the new low but on a huge positive divergence with momentum. Remember, this is often a signal to look out for a change of trend up ahead.

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From the low, the market rallied to make an interim high in mid-June. It then dipped again, then resumed the new uptrend.

I have drawn a line joining the interim highs. This line is called the neckline, as the formation beneath it resembles a shoulder on the left (LS), a head (the actual low), and a right shoulder (RS). When a bear market is ending, the head is always below both shoulders. When a bull market is ending, it's the other way around. A standard trade would be to buy when the neckline is penetrated after forming the RS.

How far should the rally take the market?

OK, so how far can we expect the rally to carry? Again, standard H&S theory states that at a minimum, the market will rally to a place equal in distance (in price) from the neckline extension as the head is away from the neckline. I have marked these distances with yellow arrows. Does it make it?

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Yes, indeed, the target was hit exactly in January 2010 for a nice 900 point gain. Also, note that the upper target line for my H&S measure also acts as one of my tramlines there is a real structure to the markets.

Now let's bring this up to date (to mid-February 2011). Here's where it gets really interesting. If I draw another tramline equidistant from the last one, this is what I find:

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In the past few days, the Dow has carried right up to this new line at the 12,300 area. Isn't that pretty? The really fascinating thing is that I could have figured out this precise target line way back in the summer of 2009 almost two years ago from a simple measurement derived from the H&S pattern. That's valuable information.

Now this example shows the classic chartist picture of the H&S. But I also use these ideas on short-term charts where they can occur not necessarily at the end of big moves. It's my own little variation on the H&S theme.

Using the head and shoulders pattern in short-term trading

Here is a chart of the S&P 500 (at the end of January 2011), which is in a bull market:

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The market is in a normal corrective period and has made a typical three Elliott wave (A-B-C) dip to the 1,265 low (marked head and wave C). The market rallied, then dipped to the RS, where I could then draw a neckline between the two interim highs. Buy orders can then be entered as the market moved up through the neckline.

Now that there's a confirmed H&S pattern, is it possible to figure out some price targets by putting more tramlines in place? Well, just look at how trading developed from there:

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Since the market was already in a bull market, we shouldn't be surprised to see it just take off and look at how it has hit all the targets. These targets are derived in exactly the same way as in the Dow example above. Again a very pretty picture.

When I spot a potential H&S pattern, I draw my neckline (which often acts as one of my tramlines), and then draw my equidistant parallel lines to give me likely targets for profit-taking.

I don't want too many lines on your chart, especially if I draw in the Fibonacci retrace levels as well. I generally keep two charts going on the same market and switch back and forth, especially for short-term trading.