What is Head-and-shoulder?
The head-and-shoulders pattern is one of the most reliable and well-known chart formations. It consists of three consecutive rallies. The first and third rallies—the shoulders—have about the same height, and the middle one—the head—is the highest. All three rallies are based on the same support line (or on the resistance line in the case of the reversed head-and-shoulders formation), known as the neckline.
Prior to point A, the neckline was a resistance line (see Figure)
Once the resistance line was broken, it turned into a significant support line.
The price bounced off it twice, at points B and C. The neckline was eventually broken in point D, under heavy volume, and the trend reversal was confirmed.
As the significant support line was broken, a retracement could be expected to retest the neckline (E), which is now a resistance line again. If the resistance line held, the price was expected to eventually decline to around level F, which was the price target of the head-and-shoulders formation. The target was approximately equal in amplitude to the distance between the top of the head and the neckline. The price target was measured from point D, where the neckline was broken.
The head-and-shoulders formation provides excellent information:
1. The support line. This is based on points B and C.
2. The resistance line. After giving in at point D, the market may retest the neckline at point E.
3. The price direction. If the neckline holds the buying pressure at point E, then the formation provides information regarding the price direction: diametrically opposed to the direction of the head-and-shoulders (bearish).
4. The price target. This is provided by the confirmation of the formation (by breaking through the neckline under heavy trading volume).
One of the main requirements of the successful development of this formation is that the breakout through the neckline occurs under heavy market volume. A breakout on light volume is a strong warning that it is a false breakout and will trigger a sharp backlash in the currency price.
The time frame for this chart formation evolution is anywhere from several weeks to several months. The intraday chart formations are not reliable. The longer the formation time is, the more significance should be attached to this pattern. The target is unlikely to be reached in a very short time frame.
Whereas there is no immediate suggestion regarding the length of target reaching time, common sense would link it to the duration of development of the chart pattern.
It is reasonable to emphasize the importance of measuring the target from the point where the neckline was broken. There is a tendency among new traders who use technical analysis to measure the target price not only from under the neckline but also from the middle of the formation.
This may happen as they measure the height of the head. Most head-and-shoulders formations, of course, look different from that in Figure 5.16. Prices fluctuate enough to forego any possibility of a clean-looking chart line. Also, the neckline is seldom a perfectly horizontal line.