Head & Shoulders Pattern In Small Caps

There seems to be a lot of discussion about the current bearish pattern that’s taking place in the Russell 2000 (iShares Russell 2000 Index (ARCA:IWM)). While there are likely tens if not hundreds of price patterns found throughout technical analysis, few are as popular or often discussed as the Head & Shoulders pattern. There is good reason for is this as it has forecast some major declines in financial markets. For example there was a Head & Shoulders pattern that led to the peak in the Dow back in 2007.

Should we be concerned about this bearish pattern? Does it hold any relevance? One good resource is thepatternsite.com, which does a great job of looking at the data of varies candlestick and price patterns. According to Bulkowski’s analysis, the Head & Shoulder pattern ranks number 1 among 21 well-known pricing patterns. This is based on the 4% failure rate and 22% average decline calculated by Thomas Bulkowski.

So it appears we may have good reason to take these types of setups seriously. What defines a Head & Shoulders top? There are few better resources to turn to than Robert Edwards and John Magee’s, Technical Analysis of Stock Trends – often considered the bible of Technical Analysis. Edwards and Magee seem to agree with Bulkowski stating in their book, “This [the Head & Shoulders] is one of the more common, and by all odds, the most reliable of the major Reversal Patterns.”

They continue in their writing to define what they believe is the “ideal” Head & Shoulders top:

A. A strong rally, climaxing a more or less extensive advance, on which trading volume becomes very heavy.

B. Another high-volume advance which reaches a higher level than the top of the left shoulder, and then another reaction on less volume which takes price down to somewhere near the bottom level of the preceding recession.

C. A third rally, but this time on decidedly less volume than accompanied the formation of either the left shoulder or the head, which falls to reach the high of the head before another decline sets in.

D. Finally, decline of price in this third recession down through a line (the “neckline”) drawn across the Bottoms of the reactions between the left shoulder and head, and the head and right shoulder, respectively and a close below that line by an amount approximately equivalent to 3% of the stock’s market price. This it he “confirmation” or “breakout.”

We now know what we are looking for with respect to the bearish reversal pattern in IWM. Now let's see if the latest price action meets the above mentioned criteria. Below is a daily chart of the iShares Russell 2000 ETF (IWM). I’ve marked the two shoulders and the head as well as the horizontal neckline at $108.

In the bottom panel we can see that volume has been declining with the formation of the head and right shoulder. Based on the work done by Edwards and Magee, we would need to see a breakdown to roughly $104.76, which would be 3% under the neckline. Volume on the break can also be an important ‘tell’ as bears will be looking for a strong move on heavy volume to help confirm and complete the pattern.

With this type of pattern we can calculate the expected measured move by looking at the distance from the head of the pattern to the neckline. This would take us nearly 10% low down to $98. However, it’s important to note as Bulkowski stated, only 55% of the patterns actually complete their expected measured move.

While these types of patterns garner much attention nothing matters until the neckline is broken, which Edwards and Magee point out that roughly 20% of necklines are “saved,” meaning the pattern is not 100% completed. Going forward I’ll be watching the $108 level and see if we get a break on heavily volume and if price is able to drop to $104 to confirm the move is not in fact a false breakdown. But until then we must be a patient.

Source: Technical Analysis of Stock Trends by Robert D. Edwards and John Magee (ninth edition)

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