When a substantial number of stocks and groups are in such a position, they provide the foundation for a very long and sustainable bull market. This was certainly true following major breakouts in late 1982 and early 1983. The opposite would be true at a market top, where a preponderance of large head-and-shoulders tops in key stocks and industry groups would warn of impending trouble.
represents an H&S failure and is usually followed by an explosive rally or, in the case of a failed inverse head and shoulders, a nasty decline. Chart 7-22, for Albertson’s, represents a good example of what happens after a pattern has failed to work or simply failed. In the case of a failed top, this
Chart 7-20 Albertson’s, 1998–2003, weekly.
Chart 7-21 Aflac, 1991–1995, weekly.
is probably the result of misplaced pessimism. Once the real fundamen- tals are perceived, not only do new buyers rush in, but also traders hold- ing short positions are forced to cover. Since fear is a stronger motivator than greed, these bears bid up the price very aggressively.
Failures used to be fairly rare, but they now appear to be more common, which indicates the necessity of waiting for a decisive breakout on the down- side (or the upside in the case of a reverse head and shoulders). They typi- cally develop when the pattern suggests a break in the opposite direction to the then-prevailing trend. Obviously, if this is the actual top or bottom, the formation will be valid. However, when a head-and-shoulders top forms in a bull market and does not experience a meaningful decline, this will tend to be a countercyclical signal. In fact, the very failure of the pattern may be interpreted as a sign that the prevailing (dominant) trend probably is still in force.
There are several points in the chart where the probabilities of a valid sig- nal sink below 50 percent and those of an outright failure start to increase.
Figures 7-15 and 7-16 try to address these points. Point Ain Fig. 7-15 rep- resents the bottom following the break below the neckline. The next rally, which ends at B, is a perfectly typical development because retracements are a normal, and indeed healthy, phenomenon. The price then falls to Cand something unexpected happens: Instead of following through on the down- side, as would be expected from a head-and-shoulders top, the price rises
Chart 7-22 Albertson’s, 1996–1999, weekly.
back to the neckline again. This is the first sign that things may not work out as expected. When the price once again rallies back above the neckline (D), the odds of a failure increase. The balance tips more to the bullish side when the price moves above the down trendline joining the head with the right shoulder (E). This is probably the time to cover all shorts, since the reason for going short in the first place—i.e., the breakdown—no longer exists. The nature of the trendline will have a great deal to do with the change in prob- abilities. For example, if the line is steep and has been touched only twice, it will have nowhere near as much significance as it would if it were shallow
Figure 7-15 Identifying a head-and-shoulders failure.
Figure 7-16 Identifying a reverse head-and-shoulders failure.
and had been touched several times. A refresher on trendline interpreta- tion in Chapter 4 would be a good idea at this point.
The next line of defense is the right shoulder. If the price can rally above this point (F), then in some cases it will now be experiencing a series of rising peaks and troughs. Finally, when the price moves above the head, the pattern is cancelled beyond a reasonable doubt.
If action on the long side is contemplated, it should be taken either when the price breaks above the trendline joining the head and the right shoulder (line E) or when it breaks above the right shoulder (F) on heavy volume.
Usually, such signals offer substantial profits in a very short period of time and are well worth acting on. Again, some common sense comes into play, for if the trendline joining the head and the right shoulder is unusually steep and has been touched only twice, it will not have the authority of a more shallow trendline that has been touched or approached on numerous occasions.
Inverse H&S patterns can also fail, as we see from Fig. 7-16. Again, the failure is usually followed by a fairly lengthy decline as participants who bought in anticipation of an upward breakout are flushed out when the new bearish fundamentals become more widely known. Note that the line join- ing the head with the right shoulder is more significant in this example than that in Fig. 7-15. This is because the line is shallower and has been touched on more occasions. The joint break with the neckline is also impressive and would greatly increase the odds of a failed pattern.
Chart 7-23 Andrew Corp., daily.
Chart 7-23 shows a failed head-and-shoulders top for Andrew Corp. This one developed during a very strong linear bull market. The first indication of failure would have been given when the price broke back above the neck- line after forming a small base. The clincher developed when the dashed trendline joining several rally peaks was bettered on the upside. Failed pat- terns are often followed by dynamic moves in the opposite direction to that indicated by the pattern. This means that these patterns should be viewed not with fear, but as an opportunity for profits. The degree of opportunity will depend on the strength of the signal and the closeness at which a real- istic stop can be placed (the perceived risk). In this case, the trendline was a very strong one and a stop could have been placed just below the low of the breakout day. Provided it was bought pretty close to the breakout point, this would have represented a very-low-risk, potentially high-reward trade.
Summary
In summary, there are several clues we can look for that suggest that a pat- tern will fail.
• Momentum indicators at the time of the breakout that are extremely over- sold in the case of a top or overbought in the case of a bottom
• Heavy volume on the right shoulder of a potential head-and-shoulders top. Light volume on a reverse head-and-shoulders breakout
• Failure of the price to follow through in the direction of the breakout fol- lowing a retracement move
• Failure of the overall market and other stocks in the industry group to act in sympathy
• The relative strength line failing to confirm the breakout
Head-and-Shoulders Top Review
• Price characteristics:A final rally separated by two smaller rallies at tops.
• Volume considerations:Very heavy volume on the left shoulder and some- times the head. Low and shrinking volume on the right-shoulder rally.
Immaterial on breakdown, but heavy volume preferred.
• Measuring implications:The distance from the top of the head to the neck- line is projected down at the point of breakout.
• Signs of false breakout:The presence of a second retracement rally and fail- ure to break the initial breakdown low. A rally above the trendline joining
the head and the right shoulder, provided it is not unduly steep and/or above the right shoulder.
Head-and-Shoulders Bottom Review
• Price characteristics:A final low separated by two higher lows at bottoms.
• Volume considerations:Heavy volume on the left shoulder and sometimes the head. Low and shrinking volume on the right-shoulder decline. Very high volume accompanying the upside breakout.
• Measuring implications:The distance from the bottom of the head to the neckline is projected up at the point of breakout.
• Signs of false breakout:Contracting volume on breakout. Price unable to hold the breakout for more than two sessions.
• Places to unwind position in case of whipsaw breakout:Violation of up trend- line joining head and right shoulder. Break below right shoulder, espe- cially if accompanied by expanding volume.