Head and Shoulders

Head and Shoulders Top
Head and Shoulders Top

The Head and Shoulders pattern is one of the most reliable trend reversal patterns and is usually seen in uptrends, where it is also referred to as Head and Shoulders Top, though they can appear in downtrends as well, where they are also referred to as Head and Shoulders Bottom or Inverse Head and Shoulders. As they are trend reversal patterns, the Head and Shoulders patterns requires the presence of an existing trend.

Head and Shoulders Top

Head and Shoulders Top is formed when a higher high in an uptrend is followed by a lower high. The result is a series of three peaks where the center peak, the head, is higher than the two peaks, the shoulders, on either side of it. The two shoulders do not need to be the same size or the same height, but they must be lower than the head.

Entry Signal

A line through the two valleys on either side of the head forms the neckline. When this line is broken to the down side, it completes the patterns and gives the entry signal to sell short. The neckline does not need to be horizontal, but the pattern is weaker if the neckline slopes upward in the direction of the uptrend. When the price breaks the neckline, there is often a pullback as the price retests the neckline but on low volume. This represents a second opportunity to enter sell short. It is possible to preempt the Head and Shoulders Top by placing a sell order once the right shoulder has reached its peak with a stop loss placed at the high of the head, but this is a higher risk trade and is therefore not recommended.

Price Projection

The Head and Shoulders Top pattern provides a measurable price projection, or a price target. This is measured by taking the height of the head to the neckline and subtracting it from the neckline at the point of the breakout.

Head and Shoulders Bottom

Head and Shoulders Bottom or Inverse Head and Shoulders is the opposite of Head and Shoulders Top and is formed in a downtrend when a lower low is followed by a higher low. The result is a series of three lows or dips where the low of the middle dip, which is the head, is lower than the dips, or the shoulders, on either side of it. As with the Head and Shoulders Top, the two shoulders do not need to be the same size or the same height, but their lows must be higher than the low of the head.

Entry Signal

The entry signal for the Head and Shoulders Bottom is similar to the Head and Shoulders Top, with a line connecting the two peaks on either side of the head forming the neckline. When this line is broken to the upside, it completes the patterns and gives the entry signal to go long. As with the Head and Shoulders Top, the neckline does not need to be horizontal, but the pattern is weaker if the neckline slopes downward in the direction of the downtrend. The Head and Shoulders Bottom is generally less reliable than the Head and Shoulders Top. Therefore, it would not be wise to preempt the formation of this pattern.

Price Projection

As with the Head and Shoulders Top, the Head and Shoulders Bottom provides a measurable price projection, which is measured by taking the height of the head to the neckline and adding it from the neckline at the point of the breakout.