The head-and-shoulders pattern is a bearish one of the more popular and reliable chart patterns. The inverted shape of this pattern produces opposite results, in this case, bullishness. From the name, the pattern somewhat looks like a head with two shoulders.
The pattern appears on all times frames and can therefore be used by day and swing traders as well as investors. Entry levels, stop levels and price targets make the formation easy to implement as the chart pattern provides important and easy-to-see levels
The Head and Shoulders are:
- Seen at market tops.
- Formation of the pattern:
- Left shoulder: Price rise followed by a left price peak, followed by a decline.
- Head: Price rise again forming a higher peak.
- Right shoulder: A decline occurs once again, followed by a rise forming the right peak which is lower than the head.
- Formations are rarely perfect, which means there may be some noise between the respective shoulders and head.
Both of the two shoulders, a head and a neckline are important to this pattern. The pattern is confirmed when the neckline is broken, which is after the formation of the second shoulder. The neckline is a level of support or resistance. The first step is to locate the left shoulder, head and right shoulder on the chart. In the standard head and shoulders pattern (market top), we connect the low after the left shoulder with the low created after the head. This creates the “neckline”
This pattern has four main sequential steps for it to complete itself and signal the reversal.
1. The formation of the left shoulder is formed when the stock or pair reaches a new high and retraces to a new low.
2. The formation of the head occurs when the stock reaches a higher high, then falls back near the low formed in the left shoulder.
3. The formation of the right shoulder formed with a high that is lower than the high formed in the head but is again followed by a fall back to the low of the left shoulder.
4. The price falls below the neckline. In order words, the price falls below the support line formed at the level of the lows reached at each of the three lows mentioned previously.
The most common entry point is a breakout of the neckline, with a stop above (market top) or below (market bottom) the right shoulder.