Why is the following considered bearish: Head and shoulders patterns are stated as signs of a turndown in your newsletter, but that pattern looks like a base, a surge, and a then pullback. So what is so bad about that (as long as it doesn't break support)? (January 31, 2002)
The reason stock patterns are useful in foretelling stock movements is that they represent in a graph how investors view a stock. Understanding investor sentiment as shown in a stock chart is one of the keys in understanding stock movements. In our online seminars we discuss each signature pattern and explain what to look for and what the psychology is behind each one.
In a head and shoulders pattern there is an initial attempt to rally that pulls back. No big deal; we know stocks rally and then pullback all the time. We like to see them stacking up these little pyramids one on top of the other as they move higher, preferably with volume higher on the move up and then lower on the pullback (often the pullback is to the 18 day MVA). Back to the pattern. When it makes the next move, it makes a higher high. Nothing wrong with that. On the pullback, however, it undercuts the uptrend and falls back down to the point where it tested lower on the prior bounce.
That is a problem or at least the start of a potential problem. The uptrend did not hold as the stock came all the way back to that prior low. That is a change of character in the move. Now if it happened after a longer uptrend and found its way back to he 50 day MVA, that is usually a good entry point if volume surges on the move up off the 50 day MVA. But there is another problem. It is under two prior highs, the left shoulder and the head. Those represent overhead resistance at two higher levels. Overhead resistance is where buyers bought but the stock dropped on them. They are unhappy. They tend to bail out when the stock gets back to that point.
If volume on the move up does not surge, and if the move back up does not take out the left shoulder's high, the problem gets worse. The overhead supply has held as sellers unloaded their shares. If the stock breaks below the neckline (the low of the left shoulder and the start of the right shoulder), that shows there are no buyers anymore, and the stock is heading lower. Usually it falls to a level equal to the points between the neckline to the top of the head.
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