The head and shoulders formation is one of the most significant price formations any trader should know. As a strong indication of an ending trend, the head and shoulder formation can help traders to know when a trend is over and the market has reversed direction.
Therefore, learning to recognize head and shoulder formation will generate many excellent trading opportunities for you, and stop you from making bad investments in a dead trend.
How to recognize the head and shoulder formation
As the name indicates, a head and shoulders formation consists of a left shoulder, a head, and a right shoulder and a neckline.
In an uptrend, a head and shoulders formation starts to form with the two last tops of the intact trend. So far, everything looks normal and the trend seems to be in god shape: The market forms a new high, which is accompanied by high volume. This tops forms the left shoulder of the head and shoulders formation.
After a correction with low volume, the market forms a new, higher top, the head of the formation. During the following correction, however, the market moves to roughly the same price level as the preceding low. This is the first sign the trend is in trouble: In an intact trend every consecutive high and low will be higher than the preceding high / low. Also, during the correction, the trend often breaks through its trend line.
By connecting the two bottoms, the bottom preceding the top and the bottom after it, a trader can create the neckline of the head and shoulders formation. The neckline is the most important line in a head and shoulders formation, and we will come back to it soon.
After the market has reached the price level of the preceding bottom, it turns around and tries to form a new top. This movement, however, is accompanied by a suspiciously low volume and fails to move past the preceding top. Instead, the market forms the next top at a significantly lower price level than the preceding top. It then turns around and starts to fall again.
By breaking through the neck line, the market completes the head and shoulders formation. The uptrend is now over and has turned into a downtrend. The head and shoulders formation also works as an indication of a bottom reversal. In this case, all the signs mentioned above are reversed.
How to trade the head and shoulders formation
In general, the head and shoulders formation is nothing but the end of an uptrend and the beginning of a downtrend. In hindsight, the periods of conversion are easy to spot and do not necessarily require any knowledge of the head and shoulders formation to understand them. “Why then”, many new traders ask, “bother with the head and shoulders formation in the first place?”
Once you experience the creation of a head and shoulders formation in real time, you will realize the advantages of knowing this price formation: It can help you understand trend reversals far earlier than simple trend analysis. With trend analysis it is incredibly difficult to pick up on all the little signs of an impending reversal and put them into context. Difficult decisions create mistakes. The head and shoulders formation, on the other hand, makes the decision easy.
While the completion of the double top comes with the breaking of the neckline, the first signs a trend is in trouble come far earlier.
- The unusually far reversal during after the head top is the first sign, something is wrong. At this point, the trend is still intact.
- The movement to the second shoulder is accompanied by low volume, another sign of a weakening trend you can only understand when you know the head and shoulders formation.
- When the market starts to turn after the formation of the second shoulder, you know that you are dealing with a head and shoulders formation and what will happen next.
With simple trend analysis, you would still be unsure about what will happen, and you would waste valuable time by making decisions.