Head and shoulders
The head and shoulders pattern is a reversal pattern that resemble the upper part of a person's body, specifically a shoulder on either side of a head. The line connecting the left and right armpit is referred to as the neckline. Head and shoulders is a reversal pattern that, when formed, signals the security is likely to move against the previous trend. There are two versions of the head-and-shoulders pattern for commodity trading or commodities futures trading. The head-and-shoulders top is a signal that commodity futures at Active Futures price is set to fall, once the pattern is complete, and is usually formed at the peak of an upward trend. The second version, the head-and-shoulders bottom (also known as inverse head and shoulders), signals that a security's price is set to rise and usually forms during a downward trend.
Both of these head and shoulders have a similar construction in that there are four main parts to the head-and-shoulder chart pattern: two shoulders, a head and a neckline. The patterns are confirmed when the neckline is broken, after the formation of the second shoulder.
Head and shoulders top
The head-and-shoulders top signals to chart users that a price is likely to make a downward move, especially after it breaks below the neckline of the pattern. Due to this pattern forming mostly at the peaks of upward trends, it is considered to be a trend-reversal pattern, as the price heads down after the pattern's completion
This pattern has four main steps for it to complete itself and signal the reversal. The first step is the formation of the left shoulder, which is formed when the price reaches a new high and retraces to a new low. The second step is the formation of the head, which occurs when the price reaches a higher high, then retraces back near the low formed in the left shoulder. The third step is the formation of the right shoulder, which is formed with a high that is lower than the high formed in the head but is again followed by a retracement back to the low of the left shoulder. The pattern is complete once the price breaks below the neckline, which is a support line formed at the level of the lows reached at each of the three retracement levels. The point of breakout is when traders following the pattern would enter the market
Head and shoulders bottom
The inverse head-and-shoulders pattern or head and shoulders bottom as it is frequently called is the exact opposite of the head-and-shoulders top, as it signals that the price is set to make an upward move or reverse. Often coming at the end of a downward move, the inverse head and shoulders is considered to be a reversal pattern, as the price typically heads higher after the completion of the pattern.
Just like the top head and shoulder pattern, there are four steps to this pattern, starting with the formation of the left shoulder, which occurs when the price falls to a new low and rallies to a high. The formation of the head, which is the second step, occurs when the price moves to a low that is below the previous low, followed by a return to the previous high. This move back to the previous high creates the neckline for this chart pattern. The third step is the formation of the right shoulder, which sees a sell-off, but to a low that is higher than the previous one, followed by a return to the neckline. The pattern is complete when the price breaks above the neckline. Once again, the point of breakout is the proper time to enter the market when following the head and shoulders patter.
Slope of the neckline
An ideal head and shoulders pattern has a neckline that is perfectly horizontal, however in the real world; the neckline will in fact be slanted either up or down to some degree. A head and shoulders top pattern sometimes tends to exhibit an upwards angle and a bottom head and shoulders pattern will exhibit just the opposite, a downwards angle.
Head and Shoulders is an extremely useful tool estimate and measure the possible extent of the subsequent move from the neckline. To find the distance of subsequent move, measure the vertical distance from the peak of the head to the neckline. Then measure this same distance down from the neckline. This gives the objective of how far prices can fall after the completion of the top formation.
Conversely, when measuring a head and shoulders bottom, simply measure the distance from the bottom of the head to the neckline and measure that same distance up from the neckline to determine the possible price target level after the price break above the neckline occurs.
The greater the distance between the neckline and the top or bottom of the head, the more profit potential the trade has. When the distance between the neckline and peak of the head is narrow, it is generally a good sign that the profit potential will be.
If the price reverts back to the neckline before reaching the profit target, the trade is not working out as planned and must be liquidated as soon as the price crosses back above the neckline with a head and shoulders top and crosses back below the neckline with a head and shoulders bottom pattern.