The Formation
The formation consists of a left shoulder, a head and a right shoulder. In Apple the left shoulder was formed when the price pulled back from about $680 to about $660 in an ‘outside day’. Please see Ominous Chart Pattern Precedes iPhone 5 Launch. The head was formed when the price moved above the peak of the left shoulder and subsequently fell down close to the bottom of the left shoulder. In Apple, after the head formation, there was another reaction rally that peaked lower than the top of the head and formed the right shoulder.
Neck Line & Downside
The line on the chart connecting the bottom of the left shoulder, the head and the right shoulder is known as the neck line. After breaking the neck line, in practice, the stock often retraces back to the neck line and sometimes over the neck line. If the retracement goes higher than the right shoulder, then the formation is considered invalid.
Traditional technicians place very heavy emphasis on volume pattern during the head-and-shoulders formation. Most technicians rely on the work done by Robert Edwards and John Magee, authors of the definitive, Technical Analysis of Stock Trends. According to traditionalists, the head-and-shoulders pattern is valid only if the head is formed on lower volume and the volume on the right shoulder is even lighter.
In traditional technical analysis, the downside minimum target is the distance from the neckline break equal to the distance from the head peak to the neckline. By this measure, the first downside target is about $615.
Fallibility Of The Pattern
My research shows that as time passes, the well-known technical patterns have been becoming less reliable. The traditional technical analysis no longer reliably works as described in the classical literature and as practiced by most technicians. The reason appears to be that the traditional technical patterns, support/resistance, indicators, and sentiment analysis are now well known, giving advanced indications to the smarter players as to what the market participants following traditional technical analysis would do.
The smarter players take advantage of this information, sometimes acting ahead of the traditional technical signals in the direction of the predicted signals and then exiting in the order flow generated by the technical signal. This is the reason that as the years go by, more and more break outs fail and the success rate of technical patterns diminish.
In one back test that we ran at the Arora Report, this pattern detected the ultimate top less than 50% of the time and produced meaningful downside only 67% of the time. The green background on the chart above signifies the bullish stance of our proprietary indicators and the red background signifies the bearish stance of our proprietary indicators.
For the foregoing reasons, the traditional technical analysis is only about 8% of my method. The main reason for paying attention to the head-and-shoulders pattern in Apple is because a large number of other investors trade on this pattern.
About Me: I am an engineer and nuclear physicist by background. I founded two Inc. 500 companies, and have been involved in over 50 entrepreneurial ventures. I am the chief investment officer at The Arora Report, which publishes four newsletters to help investors profit from change. Write me: Nigam@TheAroraReport.com. Follow me here and get email notification when I publish a new article.
Full disclosure: Subscribers to The Arora Report are long Apple from $131 and have taken partial profits at $360, $525, $629 and $568.
