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:-
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.
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.
-- 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.
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.