Reverse or Inverse Head
upward-sloping dashed line, when combined with the neckline, indicates that the right shoulder was really a symmetrical triangle (see Chapter 9).
Chart 7-12, for Alcan, shows another inverse head and shoulders; this time the head, as contained within the two dashed lines, is actually a rectangle.
Another rectangle develops during the formation of the right shoulder. Note how volume picks up during the rally from the final low. It contracts as the price corrects, only to expand on the breakout. Volume does not cooper- ate as nicely as this all the time, But when it does, it offers a higher degree
Figure 7-9 Classic reverse head and shoulders with volume.
Figure 7-10 Downward-sloping reverse head and shoulders.
of probability that the pattern is valid. In this instance, the upside objective was slightly exceeded just prior to the 1987 crash.
Having said all that, it could be argued that this is not a head and shoul- ders at all. Note the question mark against the left shoulder. This is because the low of the shoulder is extremely close to that of the head—it’s actually just a bit above the right-hand part of the head, so technically this is a reverse head-and-shoulders pattern. I bring this up because I believe it’s more impor- tant to apply common sense to price pattern construction than to apply strict rules.
Figure 7-11 Upward-sloping reverse head and shoulders.
Figure 7-12 Complex reverse head and shoulders.
After all, we are trying to identify battlegrounds between buyers and sell- ers from the point of view of forecasting trend reversals. If trading action does not quite match up to the prescribed rules, it really does not matter as long as the formation works. The rules are actually guidelines for action,
Chart 7-11 Aetna, 1982–1986, daily.
Chart 7-12 Alcan, 1983–1987, weekly.
not cast in stone for every situation. Remember, it always comes down to probabilities, never certainties. Following the rules exactly implies the kind of perfection that does not exist in technical analysis.
The 1982 bottom for Alcan appears in Chart 7-13, where there is a dra- matic volume increase on the breakout. This is a real treat, since it indicates extremely strong interest on the part of the buyers and signals a nice change in psychology. The market itself bottomed in August, but this stock touched its low in June. By August the right shoulder had begun to form, thereby setting up a positive divergence with the overall market. The divergence was confirmed with the completion of the reverse head-and-shoulders pattern later that month. The upside objective was reached at the initial rally peak.
Note the gap that developed on the second day of the breakout. Gaps are potential support and resistance areas. See how the September correction terminated at the upper end of the gap. An attempt to close a subsequent gap was made right in the closing sessions of the chart.
The question of the degree of price activity required to justify a right or left shoulder often arises. Chart 7-14, for St. Jude Medical, indicates a hor- izontal reverse head and shoulders. The left shoulder is a definite rectan- gle and provides a good battle between buyers and sellers. The head itself is really a double-bottom formation (described in Chapter 8). However, the right-shoulder decline may be pushing the envelope as far as the pattern definition is concerned, since it did not involve much price action. Even so,
Chart 7-13 Alcan, 1981–1982, weekly.
once the neckline was violated, the price had no difficulty in reaching its minimum ultimate upside objective.
They say that there is more than one way to skin a cat, and with price pat- terns there is often more than one way in which they can be drawn. In this spirit, Chart 7-15 features the reverse head and shoulders for St. Jude in a different way, avoiding the weak right shoulder. Note that in this instance the price more than meets the objective, but this benchmark nevertheless turns out to be a good pivotal support level for a couple of subsequent declines.
Sometimes the price action develops in such a way that it is quite diffi- cult to decide whether it represents one pattern or another. For example, Chart 7-16, for Sysco, shows a head-and-shoulders bottom with a nice increase in volume on the breakout. Chart 7-17 shows exactly the same period, but this time I have drawn in two parallel lines, indicating that the pattern may really have been a rectangle. The price even reached a two times multiple of the indicated objective. It really doesn’t matter what name we give to the price action. The essential point is that the price fell, there was a battle between buyers and sellers (the trading range), and there was a sub- sequent breakout to the upside on high volume. I bring this up because it is extremely easy to get hung up on names and definitions. My feeling is that you need to interpret these formations in a commonsense way, not according to strict formulas. Always try to form an understanding of the
Chart 7-14 St. Jude Medical, 1983–1986, daily.
underlying psychology of any trading situation, because that’s all that pat- terns are reflecting anyway. This means that if you can see a reversal of a peak-and-trough progression at a time when the price violates a support or resistance trendline, chances are that you have a reversal in trend. If volume
Chart 7-15 St. Jude Medical, 1983–1986, daily.
Chart 7-16 Sysco, 1981–1983, daily.
is sympathetic to your interpretation, so much the better. Remember, we give price patterns names only so that we can more easily recognize reversal phe- nomena.