A head-and-shoulders top is considered a bearish signal. It indicates a possible reversal of the current uptrend to a new downtrend.
The head-and-shoulders top is an extremely popular pattern among traders because it’s one of the most reliable of all formations. It also appears to be an easy one to spot.
Novice investors often make the mistake of seeing a head-and-shoulders top everywhere, but seasoned technical analysts will tell you that it is tough to spot the real occurrences.
The classic head-and-shoulders top looks like a human head with shoulders on either side of the head. A perfect example of the pattern has three sharp high points, created by three successive rallies in the price of the financial instrument.
The first point — the left shoulder — occurs as the price of the financial instrument in a rising market hits a high and then falls back.
The second point — the head — happens when prices rise to an even higher high and then fall back again.
The third point — the right shoulder — occurs when prices rise again but don’t hit the high of the head.
Prices then fall back again once they have hit the high of the right shoulder. The shoulders are definitely lower than the head and, in a classic formation, are often roughly equal to one another.
A key element of the pattern is the neckline. The neckline is formed by drawing a line connecting two low price points of the formation.
The first low point occurs at the end of the left shoulder and the beginning of the uptrend to the head. The second marks the end of the head and the beginning of the upturn to the right shoulder. The neckline can be horizontal, or it can slope up or down.
The pattern is complete when the support provided by the neckline is “broken.” This occurs when the price of the financial instrument, falling from the high point of the right shoulder, moves below the neckline.
Technical analysts will often say that the pattern is not confirmed until the price closes below the neckline — it is not enough for it to trade below the neckline.
Volume is extremely important for this pattern. Volume is highest when the left shoulder is forming. In fact, volume is often expanding as the uptrend continues and more and more buyers want to get in.
Volume is lowest on the right shoulder as investors see a reversal happening. Experts say low volume levels on the right shoulder are a strong sign of a reversal.
In the head portion of the price pattern, volume falls somewhere between the strength of the left shoulder and weakness of the right shoulder. Volume often increases when the neckline is broken as the reversal is now complete and downside pressure begins in earnest. One of the key characteristics we want to see in a head-and-shoulders top is very high volume on the breakout.
Although volume is important, experts warn us not to get caught up in the precise number of shares being traded. What’s more important is a change in the rate of trading.
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