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Head and shoulders pattern

Head and shoulders pattern The "head and shoulders pattern", in technical analysis, is believed to be one of the most reliable trend-reversal patterns. On the technical analysis chart, when a price trend is in the process of reversal either from a bullish or bearish trend, a characteristic pattern takes shape and is recognized as reversal formation.

A technical analysis term used to describe a chart formation in which a stock's price:
  1. Rises to a peak and subsequently declines.
  2. Then, the price rises above the former peak and again declines.
  3. And finally, rises again, but not to the second peak, and declines once more.

The first and third peaks are shoulders, and the second peak forms the head.



  1. Head and shoulders top

    : Head and shoulders pattern formation consists of a left shoulder, a head, and a right shoulder and a line drawn as the neckline. The left shoulder is formed at the end of an extensive move during which volume is noticeably high. After the peak of the left shoulder is formed, there is a subsequent reaction and prices slide down to a certain extent which generally occurs on low volume. The prices rally up to form the head with normal or heavy volume and subsequent reaction downward is accompanied with lesser volume. The right shoulder is formed when prices move up again but remain below the central peak called the Head and fall down nearly equal to the first valley between the left shoulder and the head or at least below the peak of the left shoulder. Volume is lesser in the right shoulder formation compared to the left shoulder and the head formation. 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.
Polls
  1. Head and shoulders bottom

    : This head and shoulders pattern formation is simply the inverse of a Head and Shoulders Top and often indicates a change in the trend and the sentiment. The formation is upside down in which volume pattern is different than a Head and Shoulder Top. Prices move up from first low with increase volume up to a level to complete the left shoulder formation and then falls down to a new low. It follows by a recovery move that is marked by somewhat more volume than seen before to complete the head formation. A corrective reaction on low volume occurs to start formation of the right shoulder and then a sharp move up that must be on quite heavy volume breaks though the neckline.
Another difference between the Head and Shoulders Top and Bottom is that the Top Formations are completed in a few weeks, whereas a Major Bottom (Left, right shoulder or the head) usually takes a longer, and as observed, may prolong for a period of several months or sometimes more than a year.

Head and shoulders trading

First, if the price drops to new lows on the third day, then it is unlikely to reach back to the neckline. If you are waiting for a pullback in the price to enter the trade, a new low on the third day is a good time to enter.

Second, if the price does pullback towards the neckline, you have a high probability trade that is more likely to bounce back down from the neckline to new lows. Planning a short entry as the price nears the neckline creates a potentially high-reward setup because the trend change to the downside can be so large.

Third, if you already own the stock and you see its price breakout below the neckline of a head and shoulders pattern, you should consider exiting the stock if the price makes a new low on the third trading day after the breakout. This tactic assumes that you have not already been taken out of the trade by a stop loss you previously set.

Like many technical signals, the head and shoulders pattern is more useful when it strictly conforms to the rules discussed here. More experienced traders may "bend the rules" a little when they see something that comes close, but I suggest starting to look for the strongest patterns and gain some confidence before moving on. Because the head and shoulders pattern is a strong reversal signal it can be useful for bears looking for a short entry point, and bulls trying to time an exit from a longer term bullish position.


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