The technical definition of a head and shoulders chart pattern is: a trend reversal pattern.
This popular chart pattern is a reversal from an up trend to a potential down trend. Potential change of trend is the key to remember.
Trading this chart pattern takes patience. Trend reversals take longer than continuation patterns. Reversing a trend requires a change of bias by large funds. The up trend created by significant demand is known as the mark up in the price action phase.
The concept behind a head and shoulders top is that buyers were unable to generate enough demand to push price beyond the most recent high. This is how the “right shoulder” of the pattern is formed.
Beautiful symmetry is the reason why this pattern is easy to identify. During an up trend, you will often see a textbook left shoulder leading to a new high in prices which forms the “head.” It’s only when the right shoulder starts to form that you start to plan for a potential change of trend.
The Significance of the Head and Shoulders Pattern “Neck Line”
Technical analysis is simple. Pay attention to where buyers or sellers did something significant. As traders we tend to clutter things up when we don’t trust what we see. This usually happens because of one losing trade. We no longer “believe” it works.
Successful trading requires belief. You must trust your edge over time. The neckline of the head and shoulders pattern represents a price where buyers took a stand. If price (supply) can push and hold below this level, a potential change of trend is confirmed.
This is the reason a neckline break is the entry signal for the head and shoulder top. (the red horizontal line in the chart above) If supply is greater than previous demand, something significant has happened. There are two entry tactics to consider when a neck line line break occurs.
How to Trade the Head and Shoulders Top
You have two choices for entry. One is the immediate break down through the neck line. The second is to wait for price to confirm the break. Obviously the second is the conservative of the two and becoming more common with the amount of noise created by computers these days.
Many traders will wait for price action to penetrate the neck line support to the down side and them wait for a test of that level to know hold as resistance. This is when you have to wear your trade manager hat and decide what type of stop-loss you will employ. Often price action will return and perfectly test the level and perhaps even break it. You will need to have a planned method for determining if you have a hard stop-loss at this level or if you will give the trade a little wiggle room.
I bring this up because in today’s market it is common for price to reach a significant level, triggering stop orders, then doing exactly what you anticipated would occur. THis actually brings up the point to never place your stop-loss at the exact support or resistance number.
I touch on the a little more in the video below.
Video: How to Identify and Trade the Head and Shoulders Chart Pattern