The Head and Shoulders is a chart pattern described by three peaks, the outside two are close in height and the middle is highest.
It is a bearish reversal chart pattern that begins with an uptrend with two higher highs (1 & 3) and two higher lows (2 & 4) which form the ” left shoulder” and “head”.
Point 5 makes a lower high which is lower than points 3 and 1 and this forms the “right shoulder”.
This illustrates that the upward trend is coming to an end although the reversal is confirmed when the price drops below the “neckline” at point 6 moving down pass the previous low at point 4.
The pattern is confirmed once the price breaches the neckline support (2 & 4).
It is also worth observing whether the ascent into point 3 is less steep than into point 1 and whether the ascent into point 5 is less steep than point 3.
If this does happen, it displays how the bulls are becoming less aggressive and the upward momentum is running out of steam adding to the probability of a reversal.
The Head and Shoulders chart pattern is considered by many traders and analysts to be one of the most reliable and accurate of all reversal chart patterns.
In summary, the Head and Shoulders chart pattern essentially represent:
- A rally to a new high
- Followed by a decline, then
- A marked uptrend forming a higher high
- A second decline, and
- A final rally to create another higher high but fails.
The line that connects the bottoms, often called the “neckline”, does not need to be strictly horizontal.
The slope of the neckline is also an important indicator:
- If the neckline slopes down, this signals bearishness, since price made a lower low prior to the right shoulder.
- If the neckline slopes up, this signals bullishness, since the price made a higher low prior to the right shoulder.
When a Head and Shoulders formation is seen in an uptrend, it signifies a major reversal.
The strength of this reversal, measured as the declining amount after the breakout, is proportional to the rise before pattern appears
Stronger preceding trends are prone to more dramatic reversals.
Volume is usually the highest at the left shoulder but most likely to deplete by breakout point. Conditions, where the volume is trending up, are more favorable.