Why is the head and shoulder pattern formed?
When stocks are in an uptrend, investors buy the stocks on minor corrections. After they buy the stocks, good news for the company—like a positive earnings result—will drive the stock higher. The stock corrects from the rise to form the left shoulder of the pattern.
Now, the investors who missed the buying opportunity during the positive market news participate. The stock rises to form the higher peak. It corrects due to selling pressure. As a result, the head of the pattern is formed.
The following chart shows the head and shoulder pattern with an entry and exit signal for a NASDAQ stock.
Stock prices will bounce at the support level. The investors who didn’t purchase before might decide it’s an attractive buying point. Also, those who want to sell more will wait for more confirmations that market psychology or fundamentals turned 180 degrees. When the stock isn’t able to hit above or meet its past high, it implies a possible change in trend. If prices fall below the support level—the neckline—the trend will reverse from an uptrend to a downtrend.
The head and shoulder pattern is used, along with volumes, to identify trends’ market tops. It’s also used to plan the trading strategy for the entry and exit signal. The above chart shows the entry and exit points. This pattern is a reliable reversal pattern. Sometimes the pattern doesn’t breakdown and it moves sideways.
Volume measures the number of a stock’s shares that are traded on the stock exchange in a day or a period of time. We’ll discuss volume in more detail later in this series.