A head and shoulders pattern is very similar to a triple, but the three peaks kind of look like a head and two shoulders! It is basically formed by a peak (shoulder), followed by a higher peak (head), and then by another lower peak (second shoulder). We are going to call this pattern the H&S dude.
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The prices may have been partying too much on the charts, and it may be time for them to take a shower. But we are not advertising a brand of shampoo here. This is simply another cool name for yet another reversal pattern in technical analysis.
Head and Shoulders Reversal Pattern
The H&S dude sometimes shows his ugly head after an uptrend (head and shoulders top). Other times, he peeks upside down after a strong downtrend (head and shoulders bottom).
Head and Shoulders Bottom DudeThe neckline of the H&S dude is the support level for a head and shoulders top and the resistance for the bottom pattern.
Here is a head and shoulders top pattern in action.
The support level or neckline is determined by connecting the lows after each peak, and once this level is broken, the pattern is confirmed. This indicates a new willingness by investors to sell at lower prices. The slope of the neckline can be either up, down, or flat. In a head and shoulders top pattern, when the slope is down, it typically produces an even more reliable signal.
Similarly in a Head and Shoulders bottom…
Head and Shoulders Bottom – USD/JPY 4 Hour ChartThe resistance level or neckline is determined by connecting the highs of each valley. Once this level is broken, the head and shoulders bottom pattern is confirmed. This indicates a new willingness of investors to buy at higher prices.When the neckline’s slope is up, it produces a more reliable signal.
Good to Know
Volume can serve as an important indicator for the head and shoulders pattern. Volume levels should be higher during the rise of the left shoulder than during the subsequent rise of the head. This decrease in volume along with new highs of the head can serve as a warning sign that a trend reversal could be on the horizon. A second warning sign may come with increasing volume levels on the decline from the peak of the head. Final signs of a reversal may come when the volume level increases further during the decline of the right shoulder.
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Just as with other patterns, once the neckline of our poor H&S dude is broken, it changes roles. It becomes resistance if it was acting as a support, and it turns into support if it was acting as a resistance.
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