The Head & Shoulders pattern is a formation which consists of three distinct sections or shapes; a left shoulder, a head, and a right shoulder. There is also a horizontal line which creates the base for the three shapes. The line is known as the neckline. This pattern can be both bullish as well as bearish. The head & Shoulders Pattern is a reversal pattern. Therefore once price advances either above or below the neckline, it indicates the beginning of a new trend.
Key aspects of the Head and Shoulders Pattern:
- Trend: The Head & Shoulders Pattern is a reversal pattern. Therefore the formation should be preceded by a well defined trend. The completion of the pattern will then mark the beginning of a new trend in the opposite direction.
- Left Shoulder: The left shoulder forms at the end of an extensive advance in price. The move generally occurs during a period of high volume. After the move up (peak), price declines to an extent to form a valley.
- Head: The Head is then formed after the valley at the end of the Left Should formation. From the valley formed at the end of the left shoulder's formation, price then rises once again to a level that is higher than the peak of the left shoulder. This move is accompanied by either normal or high volume. Then, just like the left shoulder, price then reacts and falls again on low volume. The valley should be right around the same level as the previous valley formed at the end of the formation of the left shoulder.
- Right Shoulder: The right shoulder then begins formation after the Head and resulting valley. The right shoulder in general is formed on lower volume than both the left shoulder and the head. The key aspect of the right shoulder is that its peak must be lower than the peak of the head.
- Break: Now that the Head & Shoulders pattern has been formed, all that's left is price confirmation. If price proceeds to fall below the neckline, this is considered to be confirmation of the bearish setup. In a bullish setup, price breaking above the neckline would be considered confirmation.