A head and shoulders top is a reversal pattern which occurs following an extended uptrend. This bearish pattern is named for the three highs which form a left shoulder, head, and right shoulder. The sell or short sell signal is when price breaks below the neckline which forms along the reaction lows.
Context: The head and shoulders pattern occurs after a lengthy uptrend and is a topping pattern for a stock. Volume in the formation of the left shoulder is often higher than volume in the formation of the head, confirming that price is advancing with less participation. This is a reliable indicator of a potential reversal to the downside.
Appearance: The head and shoulders pattern must follow an extended price rise or uptrend. Price makes a high which forms the left shoulder and reacts to a minor low. Price then achieves a major high (exceeding the prior high) which forms the head, and then reacts to another minor low. Price then rallies one final time to form a minor high which forms the right shoulder of the pattern. The minor lows are connected with a trend line which will often slope upward, and this trend line is referred to as the neckline. A downside break of the neckline is the sell signal or short sell signal for this pattern, and confirms its identity.
Breakout Expectation: A head and shoulders top pattern is confirmed with the downside penetration of the neckline. To determine a price objective from the confirmation level, subtract the distance from the top of the head to the neckline. Because these patterns are known to mark important and lasting tops, the downside move which follows may exceed the distance from the had to the neckline and be met with additional selling.
This stock formed a head and shoulders top after a big price advance. Once price penetrated the neckline to the downside, the stock moved lower.
Be sure to learn about the inverted head and shoulders, also called the head and shoulders bottom.
