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Looking for a top or bottom?? Use your you Head (and Shoulders!)

Extreme moves in the overall markets can make investors anxious. Often a strong bullish move feels like it will never end. In the same way, a prolonged bear market can dampen the spirits of even the most enthusiastic bulls. Analysts and pundits grow rich (and famous!) predicting the tops and bottoms of major market moves in the indices and in individual stocks. Indeed, nothing can be as rewarding as correctly identifying a top or bottom in a major stock movement. Every investor dreams of buying a stock right at its bottom, or shorting just as a stock peaks out. One method that I use in trying to gauge a top or bottom is the appearance of a reversal formation. Reversal formations are patterns in the daily price chart which suggest a reversal in the prevailing trend. Correctly identifying these patterns can make one alot of money, or save you from buying a loser.

Perhaps the most well known of all reversal patterns is the head and shoulders top and its bottom forming cousin the inverted head and shoulders bottom. The head and shoulders top is a powerful signal to GET OUT!!! A head and shoulders top looks like a series of three peaks on a daily price chart. The middle peak (the head) should be higher than the left and right peaks (the shoulders) in the chart. Motorola (MOT) formed an excellent example of a head and shoulders top earlier this year:

Motorola formed the left shoulder of its head and shoulder top in early to mid February of this year peaking around $54. The stock then retreated to under $50 before rocketing up to over $60 forming new highs. After a pullback to around $50, the stock again rallied, but this time the rally fizzled out around $55 then fell back to $50. This time however, the stock broke under $50, thus confirming a "head and shoulders" top. Investors who noted this formation and sold out of Motorola in March would have avoided the long decline the stock has undergone since then. But who can you know if the head and shoulders top is for real? Fortunately, stocks undergoing a head and shoulders reversal will show other signs of trouble as well. In the case of MOT, there are two STRONG clues that suggested this stock was in trouble. First of all, there is the volume. Notice the decline in volume on the RIGHT SHOULDER rally in mid March. ALMOST ALL HEAD AND SHOULDERS TOP WILL SHOW A MARKED DECREASE IN VOLUME AS THE STOCK RALLIES TO FORM THE RIGHT SHOULDER. The second major clue is exhibited in the MACD (moving average convergence divergence). The MACD is a trending indicator. When the MACD is rising, stocks are said to be trending up and when the MACD is falling stocks are said to be trending down. Notice on the MOT chart how the MACD continued to rise as the stock formed the left shoulder and head of the formation. But notice how the MACD was FALLING as the stock rallied into the right shoulder. When stock price rises, while MACD is falling the divergence is said to be bearish. MACD WILL OFTEN GO NEGATIVE DURING A HEAD AND SHOULDERS TOP.

Much of what applies to a head and shoulders top also applies to an inverted head and shoulders bottom. The inverted head and shoulders looks exactly like a head and shoulders top, only turned upside down. A good example of an inverted head and shoulders bottom was exhibited by Actrade Financial Technologies (ACRT) earlier this year from March until June:

Again, the volume and the MACD helped to tell the whole story. Notice how the selling decreased as the stock declined to form the "head" of the inverted head and shoulders. The volume then surged as the stock rose out of the "head" and then declined again as it formed the "right shoulder". Finally, the volume began to surge again as the stock rose to break the "neckline". The stock went on to form new high in the next few months.

The head and shoulders and inverted head and shoulders are strong indicators of a major trend reversal. Learning to spot them can give a trader a chance to find the "Holy Grail" of trading: Buying the bottom and selling the top.