Head and Shoulders Pattern
What it is:
The head and shoulders pattern consists of four distinct parts: The left shoulder, the head, the right shoulder, and the neckline. Each of these four must be present for the formation to exist.
How it works (Example):
To be a true head and shoulders pattern, the volume pattern must also meet strict requirements. Volume must show a peak on the left shoulder, a lower peak at the head, and then an even lower level at the right shoulder. One simple technique to determine whether the pattern fits is to draw a downtrend line on the volume chart. If the price pattern and volume line match, then you have identified a head and shoulders formation.
The Left Shoulder: Visualize a stock rising from $55 to $85, a gain of more than 50%. Next, suppose the stock then hits a short-term peak and forms a doji candle on the heaviest volume in several months. The left shoulder should always start with a period of unusually heavy volume. Then, the stock moves sideways between $80 and $85 for several weeks.
The Head: After several weeks of consolidation, assume that a low volume breakout to just under $90 occurs. Note that the head ($90) is noticeably above the left shoulder ($85). It should "stick out" as part of the pattern. Volume on this new high should also be well below the volume of the left shoulder. This is negative volume divergence, which occurs when price goes to a new high, but volume does not make a corresponding peak -- a key warning.
The Right Shoulder: Immediately after the peak near $90, there should a high volume sell-off, with the stock pulling back to just above $80 support. The shares will then rally back to $85 on tepid volume.
The Neckline: In this particular example, what I've identified as $80 support is actually the neckline of the head and shoulders formation. The neckline is drawn across the lows of the left and right shoulders. Most frequently, it is drawn horizontally, but it can also be drawn diagonally, sloping either up or down. When the neckline is broken, then the stock is in a confirmed head and shoulders pattern. Sometimes a "filter" of either 3% or two trading days is necessary to insure that the pattern is not a "false breakout" to the downside.
Why it Matters:
The head and shoulders pattern is a major reversal formation. Typically, it takes at least two to three months to complete -- and sometimes much longer. When a stock breaks below the neckline, there is no longer any support and very rapid declines can occur, often on increasing volume.
A confirmed head and shoulders formation offers an excellent shorting opportunity. On the other hand, it can also provide an early warning sign for those with long positions to sell quickly. Often, traders will mistakenly hold on in "hope" that the stock will bounce back. In many cases, though, they soon find out that hope is one of the most dangerous four letter words in a trader's vocabulary.