CHARTING Head and shoulders

Press, 4 December 1985, Page 44

CHARTING Head and shoulders

The head and shoulders top is an impressive pattern, and it is easy to see how it gets its name. Again this is a top formation. To the reader that should mean that the market must be in totally new high ground. Like the double top, the head and shoulders is a warning that the bull market is approaching its end and that a major reversal of trend is in the making. They can appear on both daily and weekly charts. Fortunately for the trader or investor the pattern does take some time to ilnfold. It therefore presents the investor an opportunity to make provision for searching out other investment alternatives. • Let’s take a look at the pattern on the Dow-Jones and see how a head and shoulders is formed. The market had been rising for 4% years, since January 1958. In September,-1961, it rises to 725 on good volume, before falling back briefly to touch 690, the left shoulder being formed in the process. Most authoritative works on charting claim that trading volumes should be watched to reinforce the pattern. As a general rule volume will tend to be heaviest on the left shoulder which is partly accounted for by late public participation. October sees the market marking time before having another thrust for higher levels. • In October and November more buying pressure enters the market and the index reaches new highs. Again volume tends to gather momentum. Distribution starts taking place and the buyers have temporarily exhausted themselves. Eventually the sellers gain the upper hand and the market is again forced to go down and test its lower levels. After reaching 740 the market again falls to the 690 level. The head is now formed.

9 The market now makes its third and final attempt to push for higher levels, volume at this point will tend to be noticeably lower as investors are mostly fully invested and buying Kwer is more or less exusted. Remember that it is only buying that can

sustain an upward move. The right shoulder rises to about the same levels as was reached on the left. A superb symmetrical head and shoulders pattern has now evolved. All that now need be done is draw in the “neckline” and this is drawn across the pivot points at 690. An immediate sell signal is given once the neckline is broken. Wait for the signal, there is a possibility that the market could continue upwards and if it went past the head at 740 would abort the pattern. Unlike the double top, the head and shoulders gives us a very reliable count as to the market’s downside potential. The norm is to measure the distance from the head down to the neckline and then project that same distance from the neckline downwards. This will invariably be the minimum target and you can expect lower levels. Most traders use the projected point as a place to start taking profits if they went short. In our example the Dow Jones hit a low of 530 before turning up again. Will all head ana shoul-

ders patterns be so clearly defined as in our example? Of course not. Some will have multiple shoulders on each .side of the head. Volumes will not confirm precisely. The neckline will hardly ever be straight. More often than not it will tend to have a pronounced slant from left to right or right to left.

Often the neckline will be penetrated and the market will move lower, then come back and touch the neckline again before proceeding down again. But this should not disguise the fact that you have one in the making. Charting is an art not an exact science. Symmetry is not a prerequisite for a valid head and shoulders. Many professional traders have a tendency to sell the rally on the formation of the right shoulder if they suspect the pattern and then add to their position (sell more) once the neckline is broken. . For conservative traders and investors the breaking of the neckline is your opportunity to liquidate. In the next article we will examine secondary tops.

Charting is an important approach to investing in shares and futures overseas, and there is growing interest in New Zealand. This is the second in a series of articles on charting by GEORGE PRICE, futures broker with Egden Wignall and Company, of Christchurch.