Head and shoulders
A head and shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal. The pattern contains three peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected to form support, or a neckline.
As its name implies, the head and shoulders reversal pattern is made up of a left shoulder, head, right shoulder and neckline. Other parts playing a role in the pattern are volume, the breakout, price target and support turned resistance.
It is important to establish the existence of a prior uptrend for this to be a reversal pattern. Without a prior uptrend to reverse, there cannot be a head and shoulders reversal pattern, or any reversal pattern for that matter.
While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder (1). The low of the decline usually remains above the trendline, keeping the uptrend intact.
From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline (2). The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy.
The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline. Although many TA gurus advocate shorting as the Neckline is broken, the lowest risk trade comes from shorting as the price starts to decline from a right shoulder, with a buy stop just above the peak of the right shoulder.
The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal. The slope of the neckline will affect the pattern's degree of bearishness: a downward slope is more bearish than an upward slope. Sometimes more than one low point can be used to form the neckline.
As the head and shoulders pattern unfolds, volume plays an important role in confirmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing volume levels. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. This decrease in volume along with new highs that form the head serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head. Final confirmation comes when volume further increases during the decline of the right shoulder.
The head and shoulders pattern is not complete and uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincing manner with an expansion in volume.
Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break and offer a second chance to sell.
After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a price target. Any price target should serve as a rough guide and other factors should be considered as well. These factors might include previous support levels, Fibonacci retracements or long-term moving averages.
Edwards and Magee stipulated that one reason why the head and shoulders pattern appears on the chart is due to distribution of shares by people who have reason to believe that the price has reached a peak.
Initially there might be too many shares to sell at once held by these people, they are not in a collusive group, but their common aim makes their actions similar, they decide that they want to sell their shares and so they begin to do so, this changes the supply and demand situation enough to cause a reaction in the price; the sellers then stop selling to avoid pushing the price down too far, the volume at this point may have seen a slight rise but this falls away as they stop selling, they allow the price to rally again above the peak caused by their selling, this new price brings in a host of new buyers for them to distribute their remaining shares to, this then causes another top, at which point all or at least most of the shares held by the original sellers have now changed hands, the price declines until it reaches the previous low, at which point people remember what happened the last time they saw this price and so they begin buying again, the buying will be weak though and on low volume. It, therefore, doesn't last long and the price once again begins its decent; this time though, the support does not hold and panic selling begins to take place, this causes the peak in volume which should accompany the breakout.