Trading Considerations: The Almighty Head And Shoulders Top Pattern

By Chris Blanchet

The Head and Shoulders Top is considered one of the most popular and reliable pattern when it comes to technical analysis. The reason for its popularity has to do with how easily new and seasoned investors can recognize it. And the reason it is considered one of the most reliable classic patterns is that it seldom produces false positives.

What a Head And Shoulders Top Looks Like Quite simply, the Head and Should Top pattern resembles a human. The head (the highest peak) has two shoulders on each side (smaller peaks). The patterns is formed when a rally experiences a pull-back, followed by another rally that reaches a higher high than the last, and then a third rally (the right shoulder) that reaches the same left as the first (left shoulder).

As far as technical analysis is concerned, the head and shoulders pattern also needs to meet a volume requirement. To prove the legitimacy of this pattern, the first rally (or left shoulder) should see heavier volume than the remaining rallies.

Technical Considerations Aside from the volume requirement and of course the visual appearance of the head and shoulders top, investors should consider that the two shoulder rallies will peak at the same price, or thereabouts. Another consideration would be the neckline (the line that can be drawn between the toughs following the first and second rallies). While necklines do not need to meet a particular criteria, when the neckline slopes upwards, the pattern is considered more bullish versus a flat or downward-sloping neckline (for strong, bearish trades seek downward sloping necklines).

Another key point is that the pattern should take shape above a comparable moving average (MA). Typically, the 50-day moving average will work just fine, but investors are advised to use the 200-day moving average for longer-term patterns. And speaking of Moving Averages, the MA should be trending in the same direction as the Head and Shoulders top. If it doesn't, then it simply means the pattern is less reliable.

Trading The Head and Shoulders Top Since this is a bearish pattern, investors are advised to sell their position or take a short position in the underlying security. Investors who look to make trades based on the head and shoulders pattern should understand that the longer it takes for the pattern to develop, the longer it will take for the price to reach its target level. With this in mind, investors should also look at the inbound trend to determine whether it simply a period of consolidation or a legitimate head and shoulders. The rule of thumb here is that the inbound trend is longer than the trend of the pattern itself.

There are literally hundreds of securities that create head and shoulders tops after every trading day. The strength of this pattern will differ from security to security, which makes it difficult for investors to trade. As well, considerable knowledge of technical analysis is generally needed to properly identify the pattern. Consequently, for beginners or hands-off traders, trading software is often recommended. - 23204

About the Author:

With more than 16 years of experience as a Financial Advisor for one of the world's largest commercial banks, Chris Blanchet is responsible for the Free Technical Analysis Course at Online Trader Today.com. He also maintains a Debt-Free Blog at How To Repay Debt.com.