Official Terminology

Since there are multiple parts to this pattern, it is important that you fully understand all components that eventually complete the head and shoulders. In order to keep things brief, our terms will be focused on a breaking to the downside, but simply flip things around to create a breakout to the upside.

Neckline – This is basically the straight line that the left shoulder and head should bounce off of, while the right shoulder eventually breaks below this line. The neckline could slope up, slope down, or be a straight horizontal line.

Left Shoulder – This shoulder is the first peak that creates our pattern, and it is the highest point of the trend up to that point. The peak should then be followed by a decline, which then bounces off the neckline, thus, creating our first shoulder.

Head - Once that decline of the left shoulder is complete, a rise in the stock price should occur and eventually create another peak. This peak should be higher than the left shoulder, and it should decline just like the left shoulder bouncing off the neckline. Now our head is apparent.

Right Shoulder – In order to complete our pattern, we need to see the right shoulder. It should be somewhat similar to the left shoulder. Once the stock begins to decline from the peak of this shoulder, the price should eventually break below the neckline. This initiates the entire pattern and any possible orders you have.

Overall Concept

Just like most patterns, a break in the neckline should be done with greater than normal volume. The main point of this pattern is to eventually create a price target, once the stock breaks past the neckline.

Once the neckline is broken through, the price target is created by simply mirroring the distance from the neckline to the peak of the head over the neckline. Depending on which type of trend reversal is occurring, the neckline then acts as a support or resistance.

Quick Check: Stock A was on a downward trend when the head and shoulders pattern broke through the trend line. What type of order would benefit the most from this breakout?

Answer: A buy order would benefit us the most, since the reversal of this pattern was happening on a downward trend. If Stock A was on a upward trend when it broke the neckline, then we would be more incline to sell or create a short position.

Like many patterns, head and shoulders is a subjective pattern. What may seem like a proper shoulder, might not to somebody else. In order to try and limit risk, it is key to use other indicators like trend lines and other patterns to help create a more reliable trade.

Concept in Action

As seen in the chart above, there are many contributing factors to creating an accurate head and shoulders. Once that right shoulder broke below the neckline, it would have signaled an end to the current uptrend. At this point we would have either sold any positions we have or create some short positions.

Our price target would have been created by taking the distance between the neckline and peak of the head and reflecting it over the neckline.

Another great point this charts shows is how the neckline can turn into a resistance once broken. If the head and shoulders was upside down, then the break would of signaled a buy call and that neckline would be support.

Important Notes and Reminder

• The peak of the head should be larger than the left and right shoulder.
• The greater volume on a break of the neckline, the more likely for the pattern to stay on track.
• It is important to acknowledge a solid trend before naming the left shoulder.

If used correctly the head and shoulders pattern can be very effective. On the other hand, there are many components to this pattern, so if they are not followed, then the pattern could prove to be disastrous or not helpful at all.

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