and Shoulders Top (Reversal)
A head and shoulders reversal pattern forms after an uptrend, and its
completion marks a trend reversal. The pattern contains three successive peaks
with the middle peak (head) being the highest and the two outside peaks
(shoulders) being low and roughly equal. The reaction lows of each peak can be
connected to form support, or a neckline.
As its name implies, the head and shoulders reversal pattern is made up of a
left shoulder, head, right shoulder and neckline. Other parts playing a role in
the pattern are volume, the breakout, price target and support turned
resistance. We will look at each part individually and then put them together
with some examples.
- Prior Trend: It is important to establish the existence of a prior
uptrend for this to be a reversal pattern. Without a prior uptrend to reverse,
there cannot be a head and shoulders reversal pattern, or any reversal pattern
for that matter.
- Left Shoulder: While in an uptrend, the left shoulder forms a peak
that marks the high point of the current trend. After making this peak, a
decline ensues to complete the formation of the shoulder (1). The low of the
decline usually remains above the trendline, keeping the uptrend intact.
- Head: From the low of the left shoulder, an advance begins that
exceeds the previous high and marks the top of the head. After peaking, the
low of the subsequent decline marks the second point of the neckline (2). The
low of the decline usually breaks the uptrend line, putting the uptrend in
- Right Shoulder: The advance from the low of the head forms the
right shoulder. This peak is lower than the head (a lower high) and usually in
line with the high of the left shoulder. While symmetry is preferred,
sometimes the shoulders can be out of whack. The decline from the peak of the
right shoulder should break the neckline.
- Neckline: The neckline forms by connecting low points 1 and 2. Low
point 1 marks the end of the left shoulder and the beginning of the head. Low
point 2 marks the end of the head and the beginning of the right shoulder.
Depending on the relationship between the two low points, the neckline can
slope up, slope down or be horizontal. The slope of the neckline will affect
the pattern's degree of bearishness: a downward slope is more bearish than an
upward slope. Sometimes more than one low point can be used to form the
- Volume: As the head and shoulders pattern unfolds, volume plays an
important role in confirmation. Volume can be measured as an indicator (OBV,
Chaikin Money Flow) or simply by analyzing volume levels. Ideally, but not
always, volume during the advance of the left shoulder should be higher than
during the advance of the head. This decrease in volume along with new highs
that form the head serve as a warning sign. The next warning sign comes when
volume increases on the decline from the peak of the head. Final confirmation
comes when volume further increases during the decline of the right shoulder.
- Neckline Break: The head and shoulders pattern is not complete and
uptrend is not reversed until neckline support is broken. Ideally, this should
also occur in a convincing manner with an expansion in volume.
- Support turned resistance: Once support is broken, it is common for
this same support level to turn into resistance. Sometimes, but certainly not
always, the price will return to the support break and offer a second chance
- Price Target: After breaking neckline support, the projected price
decline is found by measuring the distance from the neckline to the top of the
head. This distance is then subtracted from the neckline to reach a price
target. Any price target should serve as a rough guide and other factors
should be considered as well. These factors might include previous support
levels, Fibonacci retracements or long-term moving averages.
Archer Daniels (ADM) formed a head and shoulders reversal with a slightly
upward sloping neckline. Key points include:
- The low at 17 1/2 marked the end of the left shoulder and the beginning of
the head (1).
- During the advance to 20 1/2, volume was still high, but not as high as
during the left shoulder advance. However, during the next advance to 20,
volume tapered off significantly.
- Volume continued to decline until the breaking of the neckline (note red
line on volume bars).
- The decline from 20 1/2 to 17 1/2 formed the second low point (2).
- During the decline of the right shoulder and neckline break, volume
expanded (red oval) and Chaikin Money Flow turned negative.
- After the initial decline, there was a return to the neckline break (black
arrow). Even during this decline, Chaikin Money Flow remained negative. The
subsequent decline took the stock below 11.
- The measurement from neckline to the top of the head was 3. With the
neckline break at 17 1/2, this would imply a move to around 14 1/2. The July
'98 low was 13 1/2. After a decline from 20 1/2, at least a short reaction
rally could have been expected.
The head and shoulders pattern is one of the most common reversal formations.
It is important to remember that it occurs after an uptrend and usually marks a
major trend reversal when complete. While it is preferable that the left and
right shoulders be symmetrical, it is not an absolute requirement. They can be
different widths as well as different heights. Identification of neckline
support and volume confirmation on the break can be the most critical factors.
The support break indicates a new willingness to sell at lower prices. Lower
prices combined with an increase in volume indicate an increase in supply. The
combination can be lethal and sometimes there is no second chance return to the
support break. Measuring the expected length of the decline after the breakout
can be helpful, but don't count on it for your ultimate target. As the pattern
unfolds over time, other aspects of the technical picture are likely to take