Section 8:
Bearish Reversal Patterns
Head and Shoulders Top
Definition:
A head and shoulders top is very similar to a triple top. The only difference is that the second rollover from resistance is at a relatively higher level than the first and third reversals from resistance.
A head and shoulders top occurs within the context of an existing bullish trend. It starts when a stock reverses sharply lower from a high known as the left shoulder, but then rebounds from a relative low. The stock then proceeds to rise to a higher high known as the head before reversing lower for a second time to the same relative low. Next, the stock rebounds once more and rises to the third high known as the right shoulder which is equal to the first high. It rolls over once more to near the relative lows, which are connected to form a horizontal support level known as the neckline.
Nuance:
Head and shoulders tops are rare, but one of the most popular bearish reversal patterns among traders. They are extremely powerful indicators of a reversal of a bullish trend. The patterns are usually very actionable and profitable.
Head and shoulders tops sometimes appear diagonally, with a downward or upward sloping neckline, rather than horizontally.
Application:
A head and shoulders top is confirmed once the stock breaks below horizontal support known as the neckline. An entry can be taken upon the breakdown or after waiting for a retest of the neckline, which is a highly effective way of trading head and shoulders tops.
Figure 8.4
Example:
Shares of American Airlines (AMR) traced a head and shoulders top by first pulling back from the $34 level, creating the left shoulder as shown in Figure 8.4. The stock then aggressively rebounded from the $30 level and made its way up to above $40. But the stock reversed again, this time creating the head of the pattern. The stock rebounded from the $30 support level, forming two equal lows. These lows formed the neckline of the pattern. The head and shoulders top was completed when the stock rolled over from the $34 for a second time, creating the right shoulder. The pattern was confirmed when the stock broke down below horizontal support at $30.
Bearish Reversal Patterns Summary
Bearish reversal patterns predict the end of an existing bullish trend and the beginning of a bearish trend. The patterns can be applied over very short periods of time, especially in the case of 123 tops. Other bearish reversal patterns can take months or even years to play.
Reversals such as 123 tops and double tops are quite common in existing bullish trends, making these particular patterns a little more difficult to trade. Triple tops and head and shoulders tops are rare, but generally accurate and powerful signals of a pending reversal.
Trading bearish reversal patterns should be reversed for occasional trades when conditions are best for employing such a strategy. It’s best to trade bearish reversal patterns when the conditions are primed for reversals of bullish trends. Such conditions include old bullish trends, overbought conditions in the broader market or in sectors, extreme levels of optimism and greed, and divergences in price from other indicators.