The head-and-shoulders chart pattern is easy to spot, and its entry levels, stop levels and price targets make it simple for traders to use.
The left shoulder appears when the price rises to a peak and then declines. The head is formed when the price rises again to an even higher peak, then declines once more. The right shoulder is a third peak — lower than the head – rising and falling. The neckline connects the low after the left shoulder with the low created after the head.
No trade should be made until the pattern breaks the neckline, meaning the price has dropped below it.
Stops should be just above the right shoulder after the neckline is penetrated. Profit targets should be the difference between the head and low point of either shoulder. Subtract that difference from the neckline breakout level to set a downside price target.
The pattern works for several reasons.
As prices fall from the head, sellers are entering the market and there is less aggressive buying. And as the neckline approaches, many buyers feel the pain and try to exit their positions to avoid large losses. They drive prices toward the profit target.
Stopping above the right shoulder makes sense because the trend has shifted downwards and is unlikely to be broken until an uptrend resumes.