What is a Head & Shoulder Top?
A Head & Shoulders Top is a technical analysis pattern that typically appears before the end of an upward trend in the stock or futures markets, signaling a potential reversal in price. This pattern consists of three peaks, with the middle peak (the head) being higher than the two side peaks (the left and right shoulders), which are approximately equal in height.
Characteristics of a Head & Shoulders Top
As one of the common technical analysis patterns and reversal formations, the Head & Shoulders Top has the following characteristics:
- Reversal Pattern: Appears at the end of an upward trend, indicating a potential reversal in price or trend.
- Three Peaks: The middle peak (head) is higher than the two side peaks (left and right shoulders), which are approximately equal in height.
- Neckline: Connects the two lows between the three peaks with a horizontal line. The pattern is confirmed when the price breaks below the neckline.
- Measured Decline: The height from the head to the neckline represents the theoretical downward target after the neckline is broken.
- Time Span: The formation of the Head & Shoulders Top usually spans a long period, potentially covering several weeks or months.
- Volume Pattern: The volume typically decreases from left shoulder to head to right shoulder, with the left shoulder having the highest volume.
Uses of the Head & Shoulders Top
The Head & Shoulders Top is a significant technical analysis pattern used to identify a trend reversal in the market. Here are the main uses of the Head & Shoulders Top in analysis and trading:
- Predicting Trend Reversal: The appearance of a Head & Shoulders Top typically indicates the end of an upward trend and a potential transition to a downward trend. When the Head & Shoulders pattern is confirmed (i.e., the neckline is broken), investors can expect the market to turn downward.
- Establishing Short Positions: The confirmation of a Head & Shoulders Top is a signal to establish short positions. Once the pattern is confirmed, investors can consider shorting or establishing other related short positions to profit from the downtrend.
- Setting Stop-Loss Orders: For investors holding long positions, the appearance of a Head & Shoulders Top can serve as a signal to set stop-loss orders. Once the pattern is confirmed, investors can set stop-loss orders to prevent significant losses from a sharp price drop.
- Reference Price Target: Investors can use the Head & Shoulders pattern to calculate the vertical distance between the head and neckline. Once the pattern is confirmed, investors can use this measurement to predict the potential downward price target.
