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As its name implies, the head-and-shoulders pattern (Figure 1) most resembles a trader shrugging. A first peak is followed by a second, higher peak, followed by a third, lower peak. The formation usually occurs at the end of a long uptrend and is one of the most common and reliable reversal formations. Its reverse, an inverted head and shoulders at the end of a downtrend, is often less pronounced, and flatter. Either way, it is a useful pattern for catching and estimating just how far a new price move should go.

The head-and-shoulders top formation follows a prescribed script. The left shoulder is the first to emerge, accompanied to its peak by heavy volume that tapers off when price declines. The price swings back up even higher to form the head, with volume again increasing on the rally and dropping off on the decline. At this point, to rightly be called a head-and-shoulders pattern, the price must fall below the left shoulder's peak before rallying again to form the right shoulder. On the right shoulder's rally, however, volume is less than during the previous two peaks. During the development of the formation's left shoulder and head, the demand for the stock appears to be quite strong. The advance will be accompanied by heavy volume and usually positive news. Each rally, however, is actually being checked by the appearance of sellers. These sellers are taking profits with the release of the positive news. The sellers may be of such sophistication as to be one step ahead of the crowd.

The real value of the head-and-shoulders formation is the technical information revealed during the formation of the right shoulder. Because the right shoulder continues the trend but lacks volume, questions are raised as to the demand behind the advance. This lack of demand signifies an underlying imbalance is developing between the bulls and the bears. The higher prices revealed in the minor advance lends comfort to the holders of securities, while the market's inability to find more demand at higher prices indicates that the buyers are satiated. With evidence that demand is lacking on a decline, a price markdown is implied. If the decline begins to attract sellers who are disappointed longs, the probability of a move through the previous major demand levels increases. Most likely, further weakness will penetrate the demand line drawn along the major support of the formation.

The line connecting the valleys on either side of the head is known as the neckline. The neckline can be horizontal or slant up or down. When the neckline slants, the valley between the head and right shoulder should be significantly lower than the left shoulder peak.

If prices break through the neckline after the right shoulder is formed, that signals that the prices will continue in that direction. Some technicians require a breakout to travel a distance equal to 5% of the distance from the neckline to the peak of the head before they take it seriously and consider low volume on the breakout to be a warning that the signal is false and the lows may be retested.

Turn this pattern upside down and you have the inverted head and shoulders (Figure 2), except the breakout must be accompanied by a large increase in volume.

In either case, the distance from the neckline to the top of the head is how far the breakout should continue to move past the neckline. It is not uncommon, however, for the price to momentarily head back to the neckline before continuing its breakout direction toward the price objective. This price objective assumes that, prior to the head-and-shoulders formation, the price moved at least the distance between the neckline and the top of the head.