Head & Shoulders Top Watchlist Methodology
The head and shoulders top pattern is recognized as one of the most reliable bearish trend reversal patterns. Our data for over 3,000 HST patterns shows that it is successful 73% of the time and reaches its target price 59% of the time. Bulkowski* reports that 93% of these patterns continue to move downwards once a breakdown occurs. It forms after an uptrend and is characterized by three peaks with the center peak higher than the two adjoining peaks. The neckline is a line drawn between the two intraday lows between the peaks.
Our own research and backtest results are in the Newsletter Archive.
We recognize two types of head and shoulder top, depending on the slope of the neckline. We do this so we can recognize a breakdown price and issue alerts when this price is met.
When the neckline is flat or slopes upwards, the breakdown price is calculated as the point where the neckline intersects the price line following formation of the right shoulder. It is at this point that the pattern is completed and a long position should be closed, or a short position opened. At this time we can calculate a 'target' decline which is the distance between the center peak's high and the neckline. Bulkowski* estimates this target is reached 63% of the time.
If the neckline slopes down, then it is possible that it will never intersect the price line following the right shoulder, so we use an alternative method of detemining a breakdown price. In this case we use the support level between the left shoulder and the head and calculate the target price as the difference between that support level and the center peak's high.
Our algorithm will recognize a head and shoulders top pattern when the following conditions are met.
- The stock must be in a confirmed up trend before the pattern begins. An uptrend exists if the the left shoulder is at least 30% higher than the low in the previous 6 months (120 trading days).
- The pattern width, shoulder-to-shoulder, must be 6 months (120 trading days) or less.
- The head must have occured within the last 6 months (120 trading days).
- There must be approximate symmetry to the pattern. We determine this by requiring that number days between the shoulders and the head (a and b in the diagram) must be within 50% of each other.
- There must be a noticeable trough between the left shoulder and the head (c). We chose an arbitrary minimum of 2%. This is measured from the left shoulder intraday high to the intraday high at the left neckline.
- There must be a noticeable trough between the head and the right shoulder (d). We chose an arbitrary minimum of 2%. This is measured from the right shoulder intraday high to the intraday high at the right neckline.
- For upward sloping necklines, the breakdown price is the the neckline value on the date of the last close.
- For flat or downward sloping neckline, the breakdown price is the value of the intraday low at the left neckline.
- The last close must be above the breakdown price.
- The minimum 50 day average volume must be at least 500,000. Stocks with greater liquidity are less likely to make sudden moves creating a short squeeze.
© breakoutwatch.com 2015. All Rights Reserved.