The head-and-shoulders formation is one of the most sought after patterns because of its potential impact on a stock or market index. Once it has been correctly identified, its accuracy is very high (around 80%) and targets are easy to calculate.
But because it is highly visual, many investors jump on the pattern before the indicator has completed all of the requirements for its correct identification — and that is a major error that could lead to an unsuccessful trade.
A head-and-shoulders top should include the following:
1. A clearly identifiable pattern of shoulder, head and shoulder.
2. A “neckline” that connects the bottoms of the shoulders.
3. Volume should be highest on the left shoulder and lowest on the right.
4. A closing low that under the neckline on volume should sharply increase.
5. Even if a pattern meets all of the above criteria, more than 20% then resume their bull market, so the break under the neckline must exceed 3% in order for the formation to be complete.
With these factors in mind, let’s examine the chart of Barrick Gold Corp. (ABX):
At this stage, ABX only appears to be forming a head-and-shoulders top. The first three criteria have been met. However, like I said, at this stage more than 20% will fail to break down and instead resume their bullish ways.
In my opinion, ABX must close under $34.50 plus 3% (one more dollar, or $33.50) before we may conclude that a head-and-shoulders pattern has been confirmed.
The pattern on ABX could turn into a valid pattern (and it’s more than 5% fall today certainly brought it much closer), but it is not there yet and to “jump the gun” could prove fatal.
For further information on the head-and-shoulders reversal pattern, I suggest “The Technical Analysis of Stock Trends” by Edwards and Magee.
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