What is a head and shoulders top pattern?

The head and shoulders top pattern is a pattern that will often form at the top of a trend. It signals that the trend will probably be coming to an end. It consists of 2 shoulders, (stock highs) and 1 head in the middle that is higher than the shoulders.

In this example the stock headed up to $62.5 and came down making the shoulder. It headed back up to $67.5 making the head and made a second shoulder at $62. When the stock broke $56 that gave us a signal that it is probably heading lower.

Why is this a bearish signal? An uptrend consists of higher highs and higher lows. At first the stock is making new highs, but after the first high it pulls back a little. The stock then goes back to make an even higher high, which would show that the stock’s uptrend is continuing.

However the stock pulls back to the same low it hit before, breaking the up trending pattern. When the stock attempts to rally back up to make an even higher high, it fails to break the previous high.

After the stock broke down below $56 it was easy to spot that not only has the stock failed to make a higher high and higher low, but instead it made a lower high and is on its way to make a lower low. Both of these are characteristics of a downtrend, not an uptrend. So the trend has reversed.

volume

The volume should be high and increasing when the first shoulder forms. When the other two shoulders formed it should have lower volume. The breakout to the downside should have high volume.

Target

The target of a head and shoulders top pattern is found by subtracting the top of the head to the bottom. In this case the top would be $67.5 and the bottom is $56, so we would have a $11.5 move. $56-$11.5 gives us a target of $44.5. This stock hit the target and went past it a little.

trading the pattern

A professional trader would sell the stock on the breakout and buy it back when it hits $44.5. They would also place a stop above $56 in case the stock goes against you.

Other Patterns

Bull Flag - A short term bullish continuation pattern

Ascending Triangle - A bullish indicator that can take months to form

Base on Base - This is a common pattern in an uptrend