Is it Really a Head & Shoulders Top?

• Posted by Robert Sinn
• on May 15th, 2012

Everyone has made mention of the apparent head & shoulders top on the Russell 2000 ($IWM $RUT) over the last two weeks. Yesterday I decided to take a closer look at the IWM chart and pulled out the bible of chart patterns in order to gain some additional enlightenment as to the validity of this H&S top formation.

 

The fact is that this formation does not meet any of Edwards & Magee’s (E&M) volume profile rules for a “proper” H&S formation:

Left shoulder: “A strong rally, climaxing a more or less extensive advance, on which trading volume becomes very heavy, followed by a minor recession on which volume runs considerably less than it did during the days of rise and at the top. This is the “left shoulder.”

“Note that each and every item cited in A,B,C, and D is essential to a valid Head-and-Shoulders Top formation. The lack of any one of them casts in doubt the forecasting value of the pattern.” (Edwards & Magee)

The IWM H&S has the lowest volume at the left shoulder and the right shoulder has roughly the same volume as the head which contradicts E&M’s assertion that the right shoulder should be “A third rally, but this time on decidedly less volume than accompanied the formation of either the left shoulder or the head….”

Despite the fact that the formation is almost perfectly symmetrical and quite pleasing to the eye, the volume profile does not meet E&M’s criteria – they go on to write:

“First, the matter of volume. It is always to be watched as a vital part of the total picture. The chart of trading activity makes a pattern just as does the chart of price ranges. The two go together and each must conform to the requirements of the case.”

It must be noted that these ideas and words were formulated in 1940 – needless to say the market environment was much different in 1940 than it is today. A great deal has been written regarding volume in the current market environment and the fact that it has rarely conformed to any of the historical technical analysis principles regarding market volume profiles. The E&M rules for a H&S top make a lot of sense:

• The public/dumb money rush to buy into an overextended rally creating a volume surge at the left shoulder
• The smart money distributes their shares throughout the left shoulder and head of the formation
• the third shallower rally occurs on low volume demonstrating lack of conviction which forms the right shoulder
• Buyers who bought in during the topping formation are trapped once the neckline breaks causing capitulation selling which triggers sell stops at lower and lower levels

It makes perfect sense doesn’t it? Almost too perfect. The February – August 2011 H&S top in the S&P 500 ($SPY $SPX) was a textbook example of a modern day H&S that fit all of E&M’s criteria. However, I’m afraid this was a rare exception in the current market environment in which chart patterns are increasingly tricky and more often than not do not match E&M’s full set of criteria for a valid pattern.

One final point, E&M also made a point to emphasize that the neckline break is only confirmed once price has fallen below the neckline by an “amount approximately equivalent to 3% of a the stock’s market price.” Given that 3% is quite a large margin on a major equity index, I personally use a break of the neckline by 1% or more on a daily closing basis as offering confirmation of a neckline break; therefore, yesterday’s marginal close below the 78 level on IWM did NOT confirm the H&S top….YET.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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