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Head and shoulders

Pattern is formed of three peaks: two shoulders and head. When right shoulder is formed, if the price breaks trend line, trend will reverse.

Head and shoulders
Head and shoulders (top)

This pattern is an extension of the analysis of trend lines. An upward trend consists of a series of peaks and troughs that move up. Let's say that at one point the trend begins to weaken and starts to move horizontally for a short period of time. If price breaks line of the horizontal trend, the primary trend will reverse.

Orientation of pattern may be towards the top or the bottom. First pattern reverses upward trend and second reverses downward trend. Top head and shoulders could be found in practice more then bottom.

Top head and shoulders are formed after the equalization of supply and demand during the upward trend. At that moment left shoulder is created. After the fall of prices buyers are buying because price is low. False alarm causes falling of prices again to a level where they were. That's how head is created. Additional corrections cause right shoulder to be created.

Head and shoulders
Head and shoulders

It is of great importance to identify neckline. It connects the points that represent the minimum price at which was traded during the creation of this pattern.

Why is this line important? Because if the price after the creation of right shoulder falls 3% below this line, pattern is confirmed and can be expected that the price will fall significantly in the future.

Of course the whole process must be confirmed by volume. The largest volume should be at the creation of left shoulder. After that it should decline. In forming of the head, volume can be increased a little but not nearly as in the formation of left shoulder. Creation of right shoulder should be seen off with lower volume. If volume increases, it is a signal that the pattern is not confirmed, although it looks quite convincing. Finally, if 3% penetration of neckline occurs, it must be confirmed by a significant increase of volume.

After the penetration trend reversal will occur, but it often happens that after the penetration prices pull back to the level of neckline. In that case neck line is resistance line. Volume during this correction must not be large.

Head and shoulders could also be continuation pattern. It differs from reversal because it is facing the opposite direction.

Continuation head and shoulders
Continuation head and shoulders

You can see on picture that continuation head and shoulder is orientated like reversal head and shoulders for an upward trend.

The distance from head to neck line (measured with vertical line) can be used as a parameter for determining the level to which prices will move after the penetration. Let's say, for example, that top of the head is at the level of 100 and neck line is at level of 90. If price penetrates neck line at level 91, we could expect that price will decline to level of 81 (91-10=81).

The pattern can be applied to a downward trend (known as head and shoulders bottom). It looks like mirrored head and shoulders top.

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