What You Need to Know About Head and Shoulders Formation
Head and Shoulders Formation is one of the more reliable long-term trend change indicators.
The below chart is a portion of the December 2020 CBOT wheat daily price chart. Each vertical line represents the price range for each trading day. From about the middle of October to November 12th, December wheat traded at or above $5.86.
From October 7th to the 14th, wheat traded sideways between a low of $5.86 to a high of $6.17. While we did not know it at the time, but that sideways pattern formed the left shoulder of a head and shoulders formation.
On October 15th, the price traded above what we now call the top of the “left shoulder” to make a new contract high and continued to make new highs the next three days, with the top at $6.38 on October 20th. The next five days, it traded sideways to complete the “head” formation.
On October 28th, the price broke below the bottom of the head (neck) all the way down to $6.01 and then traded sideways through November 12th, forming the right shoulder. Note that as the right shoulder was being formed, the price never came close to making a new contract high (at the top of the head) and, yet, traded above the low prices that formed the bottom of the left shoulder.
The “head and shoulders” formation was clearly formed, but what does it mean?
Aside from catching the attention of technical analysts, it meant very little until the price traded higher than the head or lower than the bottom of the left shoulder.
On November 5th, wheat traded to a high of $6.26, expanding the height of the right shoulder, but settled all the way down to $6.09, which was bearish because it failed to settle above what had been the top of the right shoulder.
On November 12th, wheat traded down to the bottom of the left shoulder and settled just 1¼ cent above it and down 9¾ cents on the day, and technically pretty weak. If you were long wheat in the bin unpriced or long futures, you should have been nervous.
On Friday, the 13th of November, 2020, December wheat traded seven cents below the bottom of the left shoulder. That move below the bottom of the left shoulder completed the “head and shoulders” trend-changing top.
From a technical perspective, the wheat price rally from June 26th was confirmed over as of the 13th of November. It does not mean the price of wheat will fall out of bed, but it does mean a producer (or trader) should be looking for a price to sell wheat. The only tidbit of friendly news on the 13th was the settlement price was above the bottom of both shoulders. None-the-less, I think most “chart formation” technicians would now say the soft red wheat price trend is down.
An inverted “head and shoulders” is also indicative of a trend change from down to up. Note the partial chart below of the same December 2020 CBOT wheat in late June and early July of 2020.
Can you see the inverted “head and shoulders” formation? Do you see how clearly and how quickly the price formation of the right shoulder traded above the top of the left shoulder and launched a rally that extended $1.58 into late October 2020?
Practical Application of Technical Analysis in 2019
As of June 1st, 2019, 33% of the corn was not planted. Those of us more than 50 years old had heard all our lives that corn planted after the 10th of May lost one bushel per acre per day of potential yield until June 1st and then lost 2½ bushels per day of yield potential.
I did the math in June 2019 using a loss yield potential of half of what 60 years of research had shown. The resulting carryover required December corn to easily exceed $6 to ration the supply to keep us from running out of corn before the 2020 harvest.
December corn rallied $1.10 from May 13th to June 17th, peaking at $4.73 before a serious price correction. Us fundamentalists were certain corn would make new highs. Some of us fundamenta-lists were still expecting new highs when the December 2019 corn bottomed at $3.52¼ on September 9th. My failure to recognize the top was a very costly mistake for my clients.
I knew there were traders who ignored the fundamentals and made their buy and sell decisions purely on technical analysis. Such a person is Mark Davis of Crop-Side Marketing in Fairbury, Illinois. Mark, along with his sons, Craig and Clint, are proven successful market advisors using technical analysis. Mark had called the top in the 2019 corn market that I missed because I was not a student of technical analysis.
During the late winter months of 2020, Mark showed me the 2019 December corn chart. I could not see anything new. Mark pointed-out the head and shoulders formation and the significance of the right shoulder being “broken” when the price traded below the bottom of the left shoulder.
Take a look at the partial December 2020 corn chart below. Do you see the head and shoulders formation and when the price broke below the bottom of the right shoulder? That is when Mark concluded the top was in.
Three additional bearish indicators included the market action the day that formed the first line of the right shoulder, June 28th:
1) The high on the 28th of $4.68 failed to exceed the $4.73 contract high made on the 17th
2) December corn settled down 19½ cents on the day ($4.31½)
3) December corn settled 36½ cents below that day’s high! Holy cow! But, but, but… the corn was planted so late! No possible way corn yields could average more than 160 bushels per acre!
The next day, the bottom of the right shoulder traded lower than the left shoulder, confirming a head and shoulders top. And I missed it. The market was telling all of us the top was in June, but not many of us understood that language.
USDA said final 2019 corn yield was 167.5 bushels per acre compared to 175.5 in 2018 and 175.8 in 2020 as of the November 2020 Crop Production Report.
Note the Head & Shoulders Formation on August 2021 soybeans as of 1 June 2021. Some folks think this confirms a top; According to Mark Davis teaching, this formation alone does not indicate the uptrend is over. Do you see why?
Mark and Craig Davis can be reached at: 815 692 6612 mdavis@crop-side.com
You can see Crop-Side Marketing results for the past ten years at: http://www.crop-side.com/