Head and Shoulders Reversal
Head and Shoulders reversal
The pattern contains three successive peaks, with the middle
peak (head) being the highest and the two outside peaks (shoulders) being low
and roughly equal. The reaction lows of each peak can be connected to form support,
or a neckline.
As its name implies, the Head and Shoulders reversal pattern
is made up of a left shoulder, a head, a right shoulder, and a neckline. Other
parts playing a role in the pattern are volume, the breakout, price target and
support turned resistance. We will look at each part individually, and then put
them together with some examples.
Prior Trend: It is important to establish the existence of a
prior uptrend for this to be a reversal pattern. Without a prior uptrend to
reverse, there cannot be a Head and Shoulders reversal pattern (or any reversal
pattern for that matter).
Left Shoulder: While in an uptrend, the left shoulder forms
a peak that marks the high point of the current trend. After making this peak,
a decline ensues to complete the formation of the shoulder (1). The low of the
decline usually remains above the trend line, keeping the uptrend intact.
Head: From the low of the left shoulder, an advance begins
that exceeds the previous high and marks the top of the head. After peaking,
the low of the subsequent decline marks the second point of the neckline (2).
The low of the decline usually breaks the uptrend line, putting the uptrend in
jeopardy.
Right Shoulder: The advance from the low of the head forms
the right shoulder. This peak is lower than the head (a lower high) and usually
in line with the high of the left shoulder. While symmetry is preferred,
sometimes the shoulders can be out of whack. The decline from the peak of the
right shoulder should break the neckline.
Neckline: The neckline forms by connecting low points 1 and
2. Low point 1 marks the end of the left shoulder and the beginning of the
head. Low point 2 marks the end of the head and the beginning of the right
shoulder. Depending on the relationship between the two low points, the
neckline can slope up, slope down or be horizontal. The slope of the neckline
will affect the pattern's degree of bearishness—a downward slope is more
bearish than an upward slope. In some cases, multiple low points can be used to
form the neckline.
Volume: As the Head and Shoulders pattern unfolds, volume
plays an important role in confirmation. Volume can be measured as an indicator
(OBV, Chaikin Money Flow) or simply by analyzing volume levels. Ideally, but
not always, volume during the advance of the left shoulder should be higher
than during the advance of the head. Together, the decrease in volume and the
new high of the head serve as a warning sign. The next warning sign comes when
volume increases on the decline from the peak of the head, then decreases
during the advance of the right shoulder. Final confirmation comes when volume
further increases during the decline of the right shoulder.
Neckline Break: The head and shoulders pattern is not
complete and the uptrend is not reversed until neckline support is broken.
Ideally, this should also occur in a convincing manner, with an expansion in
volume.
Support Turned Resistance: Once support is broken, it is
common for this same support level to turn into resistance. Sometimes, but
certainly not always, the price will return to the support break, and offer a
second chance to sell.
Price Target: After breaking neckline support, the projected
price decline is found by measuring the distance from the neckline to the top
of the head. This distance is then subtracted from the neckline to reach a
price target. Any price target should serve as a rough guide, and other factors
should be considered as well. These factors might include previous support
levels, Fibonacci retracements, or long-term moving averages.
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