The head-and-shoulders top is an extremely popular pattern among investors because it’s one of the most reliable of all formations. It also appears to be an easy one to spot, and novice investors often make the mistake of seeing it everywhere. Seasoned technical analysts will tell you that it is tough to spot the real occurrences.
The classic pattern has three sharp high points, created by three successive rallies in the price of the financial instrument. The first point (the left shoulder) occurs as the price of the financial instrument in a rising market hits a high and then falls back. The second point (the head) happens when prices rise to an even higher high and then fall back again. The third point (the right shoulder) occurs when prices rise again but don’t hit the high of the head. Prices then fall back again once they have hit the high of the right shoulder. The shoulders are lower than the head and, in a classic formation, are often roughly equal to one another.
A key element of the pattern is the neckline. The neckline is formed by drawing a line connecting the low price point at the end of the left shoulder and the beginning of the uptrend to the head, and the low point the end of the head and the beginning of the upturn to the right shoulder. The neckline can be horizontal or it can slope up or down. The pattern is complete when the support provided by the neckline is broken. This occurs when the price of the financial instrument, falling from the high point of the right shoulder, moves below the neckline. Technical analysts will often say that the pattern is not confirmed until the price closes below the neckline.