The Head and Shoulders Reversal Pattern
What is probably the best known and most reliable of all major reversal patterns is the head and shoulders reversal. Most of the other reversal patterns are just variations of the head and shoulders.
The left and right shoulders (A and E) are at about the same height. The head (C) is higher than either shoulder. Notice the lighter volume on each peak. The pattern is completed on a close under the neckline (line 2), which can be drawn under the lost two reaction lows (point B nad D). The minimum objective is the vertical distance from the head to the neckline projected downward from the breaking of the neckline. A return move will oftern occur back to the neckline, which should not recross the neckline once it has been broken.
In generally, the basic ingredients for a head and shoulders top are as follows:
1. A Prior uptrend.
2. A left shoulder on heavier volume (point A) followed by a corrective dip to point B.
3. A rally into new highs but on ligher volume (point C).
4. A decline that moves below the prvious peak (at A) and approaches the previous reaction low (point D).
5. A third rally (point E) on noticeably light volume that fails to reach the top of the head (at point C).
6. A close below the neckline.
7. A return move back to the neckline (point G) followed by new lows.
The pattern, however, is not complete until the neckline is decisively broken on a closing basis. Until that downside violation takes place, there is always the posibility that the pattern is not really a head and shoulders top and that the uptrend may resume at some point.
The accompnaying volume pattern plays an important role in the development of the head and shoulders top. As a general rule, the head should take place in lighter volume than the left shoulder and volume on the third peakshould be noticeably lighter than on the previous two peaks. Volume should then expand on the breaking of the neckline, decline during the return move, and then expand again once the return move is over.
The method of arriving at a price objective is based on the height of the pattern. Take the vertical distance from the head (point C) to the neckline. Then priject that distance from the point where the neckline is broken. For example, the top of the head is at 100 and the neckline is at 80. The vertical distance would be the difference, which is 20. If the neckline is at 82 when broken, a downward objective would be projected to the 62 level. It is important to remember that the objective arrived at is only a minimum target.