After a rally to a new high, head & shoulders top pattern then suggests a weakness to intermediate support. Then, a second rally will take place before another decline to support. Finally, a third rally will be smaller than the previous two and a decline will then pass through support. By subtracting the difference between the level of the neckline from the breakout and the highest level, the technical target can be derived.
Just as the name suggests, the patterns boasts three highs with the middle one being higher than the two on either side. In the pattern, breakout, price target, volume, and support/resistance all play a part in making the shape look like a head, a set of shoulders, and a neckline.
Previous Trend - For this to work as a pattern, there absolutely needs to be a prior uptrend to reverse. Without it, no reversal pattern can ever take place.
Left Shoulder - Moving across the graph from left to right, we first come across the left shoulder and this marks the first peak. After the peak, a decline will then be seen to complete the shoulder-like appearance. It is important to note that the uptrend stays intact because the decline will never take it lower than the trend line.
Head - With the second high, we see the head start to take shape as the rally reaches a higher point than the first. After reaching its peak, the second point of the neckline is made after another decline. This time around, the uptrend is put under risk because the uptrend line will be broken.
Right Shoulder - The third and final peak forms the right shoulder but, as we have described previously, it remains lower than the second peak. Normally, the first and third peaks will be on a similar level. At times, the symmetry between the two can be a little off but they are normally fairly close to each other. When the third decline comes, it should break the neckline.
Neckline - By connecting the two low points, the neckline can be formed. Where the first low point marks the end of the left shoulder, the second low point will mark the end of the head and the start of the right shoulder. Of course, there will sometimes be a slope depending on which is higher and this will affect the degree of bearishness for the pattern. If the slope is going downwards, this represents a more bearish pattern than if it were sloping upwards.
Volume - Volume plays a key role in determining the extremes to which the head & shoulders appear. It is important to note that both analysing volume levels and indicators are both methods of measuring volume. During the advance of the head, the volume will ideally be lower than during the advance of the left shoulder. As this volume decreases, the new highs will form the head and will also serve as a warning. When the volume then increases on the decline, this then serves as a second warning. When the volume increases further during the right shoulder decline, final confirmation will then come.
Neckline Break - Until the neckline support has been broken, an uptrend isn't reversed and the pattern hasn't been completed. If an expansion in volume occurs at the same time, this will be considered as more convincing.
Turned Resistance - It is actually very common for support to become resistance after being broken; although it doesn’t happen all of the time, the price will often fall back to the support break which gives traders another chance to sell.
Price Target - By measuring the distance from the top of the head down to the neckline, a projected price decline can be found after the neckline support has been broken. Then, the price target can be found after subtracting this distance from the neckline. Of course, many other factors will also need to be considered and a price target should be seen as a rough guide. For example, you could include Fibonacci retracements, long-term moving averages, and prior support levels.