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Head and Shoulders Top Pattern

Head and Shoulders Pattern
The Head and Shoulders pattern (H&S) is one of the most reliable and powerful chart patterns in existence.  These patterns are used to identify tops in a stock price.  These tops can be excellent short entries if the pattern holds true and you are correct with your entry.  The head and shoulders pattern can also work in reverse.  By this we mean that if we find an inverse head and shoulders pattern on a chart we can look to enter a long position because the stock has most likely put in a bottom and has now reversed to the upside.  The head and shoulders pattern is a signal that a reversal in trend is happening before our eyes.  Tonight we will explain the pattern in detail with some recent examples of H&S patterns in tonight's charts of YELL ATRS and NX all of which have been on our bulletin short watch list previously.  We will also show you some classic H&S top patterns that have occurred on former high flyers such as AMCC CMGI CIEN GLW and SFA. 

The Crowd is Very Predictable
Head and shoulders like all technical patterns repeat themselves over and over again.  This is because the crowd is remarkably predictable in there investing or trading patterns.  Fear and greed is spelled out clearly in the price chart of a stock.  This is the foot print that smart traders use to tell us when to buy and sell a stock.  We can use this to determine what the crowd is doing or will do in the future.  The stock chart is not merely a visual representation of the stock's price but also the underlying psychology of the investing crowd.  Since the investing public reacts the same way time after time to price movement we can exploit the knowledge of that movement to achieve our results. This is why we should never trade without the use of a stock chart. 

H&S Reversal Pattern
The head and shoulders pattern is simply three successive peaks in an uptrend with the middle peak being higher.  This middle peak is considered the head.  The left shoulder is the recent previous peak.  The head happens when the left shoulders high is taken out and a new peak has been made.  The right shoulder is formed after there has been a pullback from the peak (head) and the subsequent rally attempt to get back to the high falls short.  It is called a head and shoulders top because when looking at the chart the two lower peaks form the shoulders and the middle peak forms the head. This is a bearish reversal often marking the end of a long uptrend.  When we are looking for these setups we must also look at volume as the pattern develops.  Volume reveals the underlying psychology of the crowd and it is something we cannot ignore simply because a pattern has developed. 

Greed Fear and Hope
The H&S works as a short because its pattern reveals greed fear and hope and whenever those three emotions are present failure is inevitable.  We look for volume to dip as it forms the head creating a new high with less enthusiasm than the left shoulder.  This is a warning sign that interest is beginning to fade and the current uptrend is most likely in jeopardy.  Greed dominates the action on the left shoulder as volume is strong.  This high volume as the stock peaks and does not advance further could be a sign of a blow off top.  After the initial pullback the last of the buyers come in as the stock climbs higher forming the head.  This is where the volume dries up because there are no more buyers.  Everyone who wants the stock is now in.  The last ones in fail to recognize the warning signs of failure.  They do not know that everyone is about to leave the party and leave them holding the bag. 

Volume begins to get heavier as the stock drops from this peak.  This is a sign of huge distribution and the uptrend desperately clings for its life.  Now the smart money is starting to sell as the stock pulls back.  Then after this heavy selling the volume dries up.  Those that missed the big move up the first time feel that they have a second chance and this is their buying opportunity.  They are hoping that the stock will make a new high.  They buy and the stock rallies up to form the right shoulder.  This new buying is of course on light volume and will not hold up.  Inevitably the price fails to hold and it falls again and keeps falling and the panic selling starts to mount like a snowball rolling down hill.  Fear is now the catalyst for the ultimate selling climax. 

How to Play the H&S
Conventional wisdom says that we should enter the short position when the stock breaks through the neckline (the invisible line connecting the low points on either side of the head).  The profit target should be measured by looking at the size of the pattern.  An H&S pattern that measures 3 points (the distance from the neckline to the peak of the head) should have a price target of 3 points to the downside once the price breaks through the neckline. This is called a measured move.  This giv

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