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Saturday, April 17, 2010

HEAD AND SHOULDERS TOP PATTERN – Part 2: Important Characteristics

Go back to Part 1: Head & Shoulders Top Formation

Important Characteristics of Head & Shoulders Top Pattern:

Existing Trend:
There should be an established existing UPWARD trend prior to the pattern.

Shape of Head & Shoulders Top Pattern:
1) Head & Shoulders:
Ideally, the shape Head & Shoulders should be symmetry. The Left & Right Shoulders should peak at about the same price level. The Left & Right Shoulders should also about the same distance from the Head, which means the time duration to develop the formation between the top of Left Shoulder & the Head should be about the same as that between the Head & the top of Right Shoulder.

However, in the real world, the Shoulders are rarely perfectly symmetrical. Sometimes, one shoulder is higher than the other, or takes longer time to develop.
In any case, the Left or Right Shoulder should not reach the level of the Head. If it does, the formation is actually not Head & Shoulders Top pattern.

When the peak of the Right Shoulder is lower than the peak of the Left Shoulder, it may carry a higher chance of larger price decline after the breakout, as it implies more weakness & bearish sentiments.

In addition, ideally, the shape Head & Shoulders should also be made up of three upward sharp peaks. But in real world, the Shoulders can be a bit more rounded / flat.
Also, sometimes in a more complex formation, the pattern could have more than one head and/or more than two shoulders (e.g. 2 Left Shoulders with about the same size and 2 Right Shoulders that are more or less equivalent to the Left Shoulders). Nevertheless, a more complex formation is more often seen in the Head & Shoulders Bottom than in the Head & Shoulders Top.

2) Neckline:
The Neckline that connects the two low points in between the Left Shoulder-Head and the Head-Right Shoulder can be horizontal, sloping upwards or downwards.
The slope of the Neckline could predict degree of bearishness of the pattern and hence affect the chance of severe price decline.

An upwards sloping Neckline has a weaker tendency that the price will decline further, as the higher low of the 2nd low point of the Neckline still indicates the strength of bullishness, and thus it carries lower chance of severe price decline.

A downwards sloping Neckline, which rarely happens, is more reliable as a bearish reversal signal, as it may imply stronger bearish sentiments & more rapidly increasing weakness, and hence have a higher chance of severe price decline.

The duration of the formation of the pattern from the start of the development of Left Shoulder to the break of the Neckline can take several months, normally range from 3 to 6 months.

Even when the price has declined from peak of the Right Shoulder, the pattern is not completed yet. The chances that the existing uptrend will continue are still higher than the chances of reversal to take place, as it is normal during an uptrend for the price to test a resistance level a few times, then retreat, and then resume the uptrend again.

Head & Shoulders Top pattern is only completed and confirmed when the price declines and closes below the Neckline, which serves as the key support level in this pattern.

Remember that we should always assume the existing trend (i.e. in this case is uptrend) is in force unless proven otherwise.
Therefore, it is important to wait for the price to make a decisive breakout by breaking through and closing below the Neckline support, preferably accompanied with an increase in volume, in order to avoid jumping the gun and/or prevent deceptive Head & Shoulders Top pattern.

Nevertheless, since this pattern is considered as one of the most reliable pattern and has a relatively high success rate, some aggressive & experienced traders like to enter the market when the price is declining from the peak of the Right Shoulder, provided they are sure that a valid Head & Shoulders Top is forming. But of course, this trade is much riskier and not recommended for novice traders.

Breakout Confirmation:
Sometimes, the price may also make a deceptive/invalid breakout whereby it touches below the Neckline, but then it moves back up again & resumes uptrend.
One possible way to prevent this is by having certain criteria to confirm if the breakout is a valid one.

A minimum penetration criteria for a breakout should be the price closes BELOW the Neckline support, not just an intraday penetration.
Some traders may apply certain price criteria (e.g. 3% - 5% break from the Neckline depending on the stock’s volatility) or time criteria (e.g. the breakout is sustained for 3 days) to confirm the validity of the breakout.

Traders / investors should be more cautious if the price keeps hovering around the Neckline without making a decisive break. When this happens, the reversal might never happen and the uptrend is likely to resume.

Volume should be diminishing as the pattern is forming.
Volume is the highest during the formation of the Left Shoulder, and then gets lighter as the pattern develops the Head, and should be the lightest during the formation of Right Shoulder, showing an indication that the buying pressures are getting weaker.
Ideally, during & after the breakout of the Neckline support, the volume should significantly increase again.
When during the decline from peak of the Right Shoulder, the price experiences an accelerated drop, perhaps with a gap down or two, accompanied by an expansion in volume, this might give a good sign, as the price decline tends to drop further, and hence it may provide higher chances that the pattern is a bearish reversal pattern.

Potential Price Target:
1) Compute the height of the pattern: The vertical distance between the top / peak of the Head (which serves as the resistance) and the Neckline (which serves as the key support).
2) To compute the potential price target: Subtract the result from the point where the price finally breaks Neckline.

In general, any price target should only be used as a rough guide. To determine the price target, other factors, such as previous support / resistance levels, Fibonacci retracements, or long-term moving averages, should be considered as well.

Suppose a Head & Shoulders Top pattern is forming with the Neckline is sloping downward.
The peak of the Head is at $80 and the Neckline vertically under it is at $60.
The height of the pattern is therefore 20 (80 - 60 = 20).
Suppose the Neckline was finally broken at $50.
Hence, the price target would be $30 (50 - 20 = 30).

Return to Breakout Level:
After the breakout occurs, the price may sometimes return to the Neckline for an immediate test of this new resistance level before continuing their moves in the direction of the breakout. (Remember that the support now has turned into new resistance level). It is also normally only a minor & short-lived bounce.
If this price return move happens, it could actually offer an opportunity to participate in the breakout with a better reward to risk ratio.
However, when the breakout occurs with a heavy volume, the chance of the price to return to the breakout level before continuing its downward movement will be smaller.

To find out more about other Chart Patterns, please refer to:
Learning Charts Patterns

Analysis Tool:
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Related Topics:
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Option Greek
* Understanding Implied Volatility (IV)
* Understanding Option’s Time Value