A Head and Shoulders Top is considered a bearish signal. It indicates a possible reversal of the current uptrend to a new downtrend.
The Head and Shoulders Top is an extremely popular pattern among investors because it's one of the most reliable of all formations. It also appears to be an easy one to spot. Novice investors often make the mistake of seeing Head and Shoulders everywhere. Seasoned technical analysts will tell you that it is tough to spot the real occurrences.
The classic Head and Shoulders Top looks like a human head with shoulders on either side of the head. A perfect example of the pattern has three sharp high points, created by three successive rallies in the price of the financial instrument.
The first point - the left shoulder - occurs as the price of the financial instrument in a rising market hits a high and then falls back. The second point - the head - happens when prices rise to an even higher high and then fall back again. The third point - the right shoulder - occurs when prices rise again but don't hit the high of the head. Prices then fall back again once they have hit the high of the right shoulder. The shoulders are definitely lower than the head and, in a classic formation, are often roughly equal to one another.
A key element of the pattern is the neckline. The neckline is formed by drawing a line connecting two low price points of the formation. The first low point occurs at the end of the left shoulder and the beginning of the uptrend to the head. The second marks the end of the head and the beginning of the upturn to the right shoulder. The neckline can be horizontal or it can slope up or down. The pattern is complete when the support provided by the neckline is "broken." This occurs when the price of the financial instrument, falling from the high point of the right shoulder, moves below the neckline. Technical analysts will often say that the pattern is not confirmed until the price closes below the neckline - it is not enough for it to trade below the neckline.
There are many variations, some of which are described here and can be just as valid as the classic formation. Other factors - including volume and the quality of the breakout - should be considered in conjunction with the pattern itself.
Variations of a Head and Shoulders Top
Following are some variations of the Head and Shoulder pattern that may occur.
The Drooping Shoulder
The drooping shoulder, where the neckline has a downward slope, is highly unusual and demonstrates extreme weakness. The droop happens because the price at the end of the head and the beginning of the right shoulder has dropped even lower than the previous low at the end of the left shoulder and the beginning of the head. Most experts agree that a downward slope has bearish implications for market weakness. When the right shoulder is drooping, the trader will have to wait longer than usual for a decisive neck break. It should also be noted that when that decisive break does occur much of the move will have already occurred.
Varying Width of Shoulders
The classic Head and Shoulders Top is symmetrical. However, if the shoulders don't match in width, don't discount the pattern.
While the classic Head and Shoulders Top is made up of three sharp upward points, these need not be present for the pattern to be valid. Sometimes, shoulders can be rounded.
Multiple Head and Shoulders Patterns
Many valid Head and Shoulders patterns are not as well defined as the classical head with a shoulder on either side. It is not uncommon to see more than two shoulders and more than one head. A common version of a multiple Head and Shoulders pattern includes two left shoulders of more or less equal size, one head, and then two right shoulders that mimic the size and shape of the left shoulders.
Volume is extremely important for this pattern.
For a Head and Shoulders Top the volume pattern is as follows.
Volume is highest when the left shoulder is forming. In fact, volume is often expanding as the uptrend continues and more and more buyers want to get in.
Volume is lowest on the right shoulder as investors see a reversal happening. Experts say low volume levels on the right shoulder are a strong sign of a reversal.
In the head portion of the price pattern, volume falls somewhere between the strength of the left shoulder and weakness of the right shoulder. Volume often increases when the neckline is broken as the reversal is now complete and downside pressure begins in earnest. One of the key characteristics looked for in a Head and Shoulders Top by seasoned Technical Analysts is very high volume on the breakout.
Although volume is important, experts warn us not to get caught up in the precise number of shares being traded. What is more important are changes in the rate of trading.
Following are important characteristics for this pattern.
The right and left shoulders peak at approximately the same price level. In addition, the shoulders are often about the same distance from the head. In other words, there should be about the same amount of time between the development of the top of the left shoulder and the head as between the head and the top of the right shoulder. In the real world, the formation will seldom be perfectly symmetrical. Sometimes one shoulder will be higher than the other or take more time to develop.
Volume is highest on the left shoulder, lowest on the right shoulder and somewhere in between on the head.
Duration of the Pattern
Some experts say that an average pattern takes at least three months from start to the breakout point when the neckline is broken. It is not uncommon, however, for a pattern to last up to six months. The duration of the pattern is sometimes called the "width" or "length" of the pattern.
Need for an Uptrend
This is a reversal pattern which marks the transition from an uptrend in prices to a downtrend. This means that the pattern always begins during an uptrend of prices.
Slope of the Neckline
The neckline can slope up or down. An upward sloping neckline is considered to be more bullish than a downward sloping one, which indicates a weaker situation with more drastic price declines. It is rather rare to have a downward sloping neckline for this pattern.
Duration of the Pattern
Consider the duration of the pattern and its relationship to your trading time horizons. The duration of the pattern is considered to be an indicator of the duration of the influence of this pattern. The longer the pattern the longer it will take for the price to move to the target price. The shorter the pattern the sooner the price move. If you are considering a short-term trading opportunity, look for a pattern with a short duration. If you are considering a longer-term trading opportunity, look for a pattern with a longer duration.
The target price provides an important indication about the potential price move that this pattern indicates. Consider whether the target price for this pattern is sufficient to provide adequate returns after your costs (such as commissions) have been taken into account. A good rule of thumb is that the target price must indicate a potential return of greater than 5% before a pattern is considered useful. However you must consider the current price and the volume of shares you intend to trade. Also, check that the target price has not already been achieved.
The inbound trend is an important characteristic of the pattern. A shallow inbound trend may indicate a period of consolidation before the price move indicated by the pattern begins. Look for an inbound trend that is longer than the duration of the pattern. A good rule of thumb is that the inbound trend should be at least two times the duration of the pattern.
Criteria that Supports
Support and Resistance
Look for a region of support or resistance around the target price. A region of price consolidation or a strong Support and Resistance Line at or around the target price is a strong indicator that the price will move to that point.
Location of Moving Average
The Head and Shoulders Top should be above the Moving Average. Compare the location of the pattern to a Moving Average of appropriate length. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average.
Moving Average Trend
The Moving Average should change direction within the duration of the pattern and should head in the direction indicated by the pattern. Look at the direction of the Moving Average Trend. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average.
Volume is highest when the left shoulder is forming.
Volume is lowest on the right shoulder.
In the head portion of the price pattern, volume falls somewhere between the strength of the left shoulder and weakness of the right shoulder.
A strong volume spike on the day of the pattern confirmation is a strong indicator in support of the potential for this pattern. The volume spike should be significantly above the average of the volume for the duration of the pattern.
Other reversal patterns (such as Bullish and Bearish Engulfing Lines and Islands) that occur at the peaks and valleys indicate strong resistance at those points. The presence of these patterns inside a Head and Shoulders is a strong indication in support of this pattern.
Criteria that Refutes
No Volume Spike on Confirmation
The lack of a volume spike on the day of the pattern confirmation is an indication that this pattern may not be reliable. In addition, if the volume has remained constant, or was increasing, over the duration of the pattern, then this pattern should be considered less reliable.
Location of Moving Average
If the Head and Shoulders Top is below the Moving Average then this pattern should be considered less reliable. Compare the location of the pattern to a Moving Average of appropriate length. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average.
Moving Average Trend
A Moving Average that is trending in the opposite direction to that indicated by the pattern is an indication that this pattern is less reliable. Look at the direction of the Moving Average Trend. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average.
An inbound trend that is significantly shorter than the pattern duration is an indication that this pattern should be considered less reliable.