Head and Shoulders Chart Pattern
Head and Shoulders Top
Anticipates a decline on a break below the Neckline. To trade this formation, place your order to fill on a break down below the neckline, place your stop loss order behind the head.
Head and Shoulders Bottom
Anticipates a rise in prices on a break above the Neckline. To trade this formation, place your order to fill on a break up above the neckline, place your stop loss order behind the head.
The head and shoulders pattern is generally regarded as a reversal pattern and it is most often seen in uptrends. It is also most reliable when found in an uptrend as well. Eventually, the market begins to slow down and the forces of supply and demand are generally considered in balance. Sellers come in at the highs (left shoulder) and the downside is probed (beginning neckline.) Buyers soon return to the market and ultimately push through to new highs (head.) However, the new highs are quickly turned back and the downside is tested again (continuing neckline.)
Tentative buying re-emerges and the market rallies once more, but fails to take out the previous high. (This last top is considered the right shoulder.) Buying dries up and the market tests the downside yet again. Your trendline for this pattern should be drawn from the beginning neckline to the continuing neckline. (Volume has a greater importance in the head and shoulders pattern in comparison to other patterns.
Volume generally follows the price higher on the left shoulder. However, the head is formed on diminished volume indicating the buyers aren't as aggressive as they once were. And on the last rallying attempt-the left shoulder-volume is even lighter than on the head, signaling that the buyers may have exhausted themselves.) New selling comes in and previous buyers get out. The pattern is complete when the market breaks the neckline. (Volume should increase on the breakout.)
Example of a Head and Shoulders Bottom
Here is a Head and Shoulders bottom pattern on the weekly chart of ZIXI stock.
ZIXI looks to be breaking out to the upside, and the breakout to the upside is what makes a completed Head and Shoulders pattern.
Until the stock breaks out to the upside, it is just a possible Head and Shoulders base.
When it looks like a stock is forming a Head and Shoulders base, but the pattern never breaks out to the upside, that is a failed pattern.
So the breakout of the neckline is where to look to enter the stock for a move higher.
The stop is wrong would be just below the left shoulder low, because a good breakout through the neckline, should not trade back to below the left shoulder low.