The head and shoulder pattern consists of three parts:
- After a long bullish trend, prices rise to a peak and then fall to form a valley.
- Prices rise again, well above the first peak, and form a second high that falls again.
- Prices will rise three times, but will only rise to the level of the first peak and then fall again.
The first and third peaks form the shoulders and the second peak forms the head. The line connecting the first and second valleys is called the neckline.
The inverse or reverse head and shoulder pattern is also a reliable indicator that the downtrend is about to reverse to the uptrend. In this case, the stock price will be low three times in a row, except for a temporary rise. Of these, the second trough is the lowest (head) and the first and third troughs are slightly shallower (shoulders). The recent rise after the third dip indicates that the bearish trend may be reversed and prices may continue to rise.
Tug of war
Stock prices are the result of an ongoing tug of war. Whether the stock price goes up or down is a direct result of the number of people in each team. A person who believes that the stock price will go up is called a bull, and a person who believes that the stock price goes down is called a bear. If the shareholders of more stocks are bears, the price will go down when they sell their stocks to avoid losing money. If more people are optimistic, prices will rise as new investors buy to take advantage of the opportunity.
Inverse head and shoulders
The opposite of the head and shoulders chart is the opposite head and shoulders, also known as the bottom of the head and shoulders. It reverses and uses the upper part of the head and shoulders to predict a downward trend reversal. This pattern is identified when the security price action meets the following characteristics: Prices fall to low levels and then rise. Prices fall below the previous valley and then rise again. Finally, prices fall again, but not until the second trough. When the last trough is reached, the price rises towards resistance near the top of the previous trough.