by Ian Harvey
What is a Head and Shoulders Top?
The Head and Shoulders ‘Top’ is one of two major head and shoulders chart patterns
which form the most common reversal formations, and signals to chart
users that a security's price is likely to make a downward move,
especially after it breaks below the neckline of the pattern. This
pattern occurs after an uptrend and usually marks a major trend reversal
when complete.
The Head and Shoulders
Top formation has four main steps for it to complete itself and signal
the reversal – these consist of three successive peaks -- a left
shoulder, a head (being the middle peak – and the highest), and a right
shoulder -- and a line drawn as the neckline – which forms support from
the reaction lows of the left and right shoulders.
The Components of the Head and Shoulders Top
To further define the steps that make up the Head and Shoulders ‘Top’ pattern are:-
1. The formation of the left shoulder -- where the security reaches a
new high and retraces to a new low where volume is noticeably high.
After the peak is reached a subsequent reaction occurs and prices slide
down to a certain extent which generally occurs on low volume before
rallying again to form the head.
2. The formation of the head -- when the security reaches a higher high,
then retraces back near the low forming in the left shoulder. Heavy
volume usually occurs at this point to help form the head before a
reaction sets in to cause a downward slide accompanied by lesser volume.
3. The formation of the right shoulder – when a high is formed but is
lower than the head and is then subject to a retracement back to the low
of the left shoulder -- volume is less when compared to the volume
observed with the left shoulder and the head formations.
4. The neckline – completes the pattern once the price falls below this
support line, which is formed at the level of the lows reached at each
of the three retracements mentioned above. A neckline is drawn across
the bottoms of the left shoulder, the head and the right shoulder. When
prices break through this neckline and keep on falling after forming the
right shoulder, it is the ultimate confirmation of the completion of
the Head and Shoulders Top formation. It is quite possible that prices
pull back to touch the neckline before continuing their declining trend.
It is important to remember that this pattern is not always symmetrical,
as there can be varying widths as well as heights – the critical point
is the identification of the neckline support based on volume
confirmation. The support break indicates a new willingness to sell at
lower prices. Lower prices combined with an increase in volume indicate
an increase in supply.
Examples of Head and Shoulders Topping Patterns
Example 1. Head and Shoulders Top in the Chart of the iShares Russell 2000 Index Fund
-- Showing a Violation of the Neckline --
Chart by FreeStockCharts.com Copyright©2015 Stock-Options-Made-Easy.com
Example 2. A Completed Head and Shoulders ‘Top’ in the Chart of the Vanguard Total Bond Market Index (VBMFX)
--Gapping Below Its Neckline --
Determining the Size of Movement
When price closes below the neckline – the confirmation support line – a
strong sell signal is apparent as a downward sloping confirmation line
means that prices are making lower lows, and the ”bears” are in their element.
A point of exiting the trade can be determined by the extent of the
breakout move, which can be estimated by measuring from the top of the
middle peak down to the neckline – in other words a calculation can be
made by measuring from the highest point to the neckline -- and then
transposing the same measurement from the neckline (breakout) downwards,
to estimate a target for an exit trade.
Conclusion
The Head and Shoulders
chart pattern is a heavily used and quite a profitable charting pattern
as it occurs on all times frames, and can be seen visually giving
easily understood buy and sell signals.
Implementing a trading strategy, using this pattern, is easy as it provides entry, stop and profit targets.
Like using any trading strategy, the head and shoulders top chart
pattern does not provide a perfect system, but does provide a method of
trading the markets based on logical price movements.