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Head and Shoulders

With pattern analysis, technical analysts look for specific trading patterns that have yielded consistent trends in trading history. One popular pattern is the Head and Shoulders formation.

A head and shoulders pattern occurs at market tops and predicts a trend reversal. It is formed when prices reach a peak, then dip, then form a higher peak, then dip, then form a lower peak near the same level as the first peak, then dip below the neckline (formed by the line joining the two intervening dips). A flat or downward sloping neckline is more predictive of a true head and shoulders pattern than an upward sloping neckline.

A true head and shoulders formation will then breakout downward from the neckline in a move with amplitude at least as large as the price difference between the apex of the intermediate highest peak and the neckline. Volume is usually high on the first peak, moderate on the highest peak, and low on the third peak, with a strong increase in volume on the breakout below the neckline as many technical analysts recognize the formation and confirm it with their actions. Technical traders sell the stock at the breakout below the neckline while putting a stop-loss just above the third peak in case the breakout is false and the upward trend is resumed. Traders who miss the breakout move, often wait until the price rallies back to the neckline which becomes a new resistance level. They sell at this point with a stop loss a little above the resistance level.

The duration of this pattern is variable - it can encompass weeks, months, or even years. Longer durations predict a longer reversal of the trend. When a head and shoulders pattern fails or gives a false confirmation, the original trend is resumed in a strong move as traders unwind their trades, however it portends a weakness in the trend and often reverses at a later time.

A reverse head and shoulders pattern occurs at market bottoms and predicts a trend reversal. It is formed when prices reach a trough, then rally, then form a lower trough, then rally, then form a higher trough near the same level as the first trough, then rally above the neckline (formed by the line joining the two intervening peaks). A flat or upward sloping neckline is more predictive of a true reverse head and shoulders pattern than an downward sloping neckline.

A true reverse head and shoulders formation will then breakout upward from the neckline in a move with amplitude at least as large as the price difference between the intermediate lowest trough and the neckline. Volume is usually high on the first trough, moderate on the lowest trough, high on the second peak, and low on the third trough, with a strong increase in volume on the breakout above the neckline as many technical analysts recognize the formation and confirm it with their actions. Technical traders buy the stock at the breakout above the neckline while putting a stop-loss just below the third trough in case the breakout is false and the downward trend is resumed. Traders who miss the breakout move, often wait until the price rallies back to the neckline which becomes a new support level. They buy at this point with a stop loss a little below the support level.

The duration of this pattern is variable - it can encompass weeks, months, or even years. Longer durations predict a longer reversal of the trend. When a reverse head and shoulders pattern fails or gives a false confirmation, the original trend is resumed in a strong move as traders unwind their trades, however it portends a weakness in the trend and often reverses at a later time.




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