Stock Charts

Head and Shoulders

The head-and-shoulders pattern is one of the most popular and reliable chart patterns in technical analysis. And as one might imagine from the name, the pattern looks like a head with two shoulders. 

Head and shoulders is a reversal pattern that, when formed, signals the security is likely to move against the previous trend. There are two versions of the head-and-shoulders pattern. The head-and-shoulders top is a signal that a security's price is set to fall, once the pattern is complete, and is usually formed at the peak of an upward trend. The second version, the head-and-shoulders bottom (also known as inverse head and shoulders), signals that a security's price is set to rise and usually forms during a downward trend. 

Both of these head and shoulders have a similar construction in that there are four main parts to the head-and-shoulder chart pattern: two shoulders, a head and a neckline. The patterns are confirmed when the neckline is broken, after the formation of the second shoulder. 

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Figure 1: Head-and-shoulders pattern |

The head and shoulders are sets of peaks and troughs. The neckline is a level of support orresistance. The head and shoulders pattern is based on Dow Theory's peak-and-trough analysis. An upward trend, for example, is seen as a period of successive rising peaks and rising troughs. A downward trend, on the other hand, is a period of falling peaks and troughs. The head-and-shoulders pattern illustrates a weakening in a trend where there is deterioration in the peaks and troughs. 

Head and Shoulders Top 

Again, the head-and-shoulders top 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. Due to this pattern forming mostly at the peaks of upward trends, it is considered to be a trend-reversal pattern, as the security heads down after the pattern's completion. 

This pattern has four main steps for it to...