The “head-&-shoulders” pattern is one of the most common and reliable of all the reversal patterns. It consists of a left shoulder, a head and a right shoulder.
The left shoulder is usually formed at the end of a major advance (point A on figure 4). It’s followed by a steep correction in the stock. During the recovery, the stock moves ahead to a fairly marginal new high, only to correct again. The new high is the head and it’s found at point B. Its low in the ensuing correction will usually be around the low of the previous correction. This low point is called the “neckline.”
Once the low has been reached, the stock advances again, only to falter below the previous high. This is the right shoulder (point C). The stock then rolls over and heads down to the neckline again. In a clean head and shoulders formation, the stock would, at this point, break down below the neckline.
In our example, the stock makes one last run at the old high. (Think of it as a 2nd right shoulder.) But the advance is short-lived and the stock crumbles.
The general rule is that the decline of the stock below the neckline will be the same as the distance from the neckline to the top of the head. In our example, the target area for the decline to stop is around the $140 level.
The reverse head-&-shoulders pattern is the mirror image of the head-&-shoulders formation. It follows the same rules as the head-&-shoulders but it occurs as a stock is forming a bottom.