Chart Pattern Recognition Series - Head and Shoulders Tops

The head and shoulders top is a short-term bearish reversal pattern that gives way to short opportunities. The price enters the pattern from the bottom and breaks out to the bottom thus reversing the prevailing price trend.

This pattern is among the most popular patterns to trade in the market for reasons that stem from the patterns reliability, performance and easy identification. It is a fairly simply pattern to recognize in that there will be three spikes with the center spike being the highest. More often then not the left shoulder will carry the highest volume as well.

A trend line drawn along the bottoms of the two troughs and between the three peaks is known as the neckline. The neckline is nothing more than an indicator used to predict how severe the price decline is going to be. This line slopes up half the time and down half the time. An upward sloping trend line would could suggest the stock might have a slight pullback before continuing its decline. These trend lines will serve as a new resistance point. The neckline also serves as a confirmation point. Should the price decline pierce the neckline, assuming no pullback, prices will continue to move downward to the next resistance level.

I recently pointed a stock with what I determined to be a good example of a head and shoulders pattern. That stock was Sears Holdings Corp. (SHLD). I have outlined the chart above and pointed out the critical elements of this pattern. If you could have recognized this pattern early (such as did :-) then you could have got yourself into a low risk, high reward position. If the pattern was going to break down, it was going to happen in days following the breach of the correctly identified support level. This is exactly what happened and because of the downward sloping neckline, I would suspect this pattern to continue its bearish reversal in the coming months. For now though, I am happy with the profits made and will take some off the table.