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High-Probability Trade Setups: A Chartist's Guide to Real-Time Trading by Tim Knight

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Chapter 14

Head and Shoulders

The head-and-shoulders (H&S) pattern has a funny name but a powerful purpose: to indicate the possible reversal of the security you are charting. It is one of the best known, most easy to recognize, and yet most widely misidentified patterns in technical analysis. As the name suggests, the H&S pattern looks like a head in between two shoulders, and a completion of this pattern indicates that the security is probably going to head down in price.

DEFINITION OF THE PATTERN

The criteria for this pattern are as follows:

  • Left shoulder: An ascent in price (ideally following a long, major ascent in the stock's value), a leveling, and then a weakening back to a certain support level known as the neckline.
  • Head: A further ascent in price, surpassing the high set by the left shoulder, once again leveling off and descending back to the neckline.
  • Right shoulder: A final ascent in price, ideally not going as high as the left shoulder (and certainly not going as high as the head), a leveling off, and a descent back to the neckline, which it breaks beneath on strong volume.

The target price is the value of the price range of the pattern subtracted from the neckline. For example, if a neckline is at $20, and the top of the head is $25, the difference is $5. Therefore, $20 (the neckline) minus the range ($5), equals the target price ($15). This setup anticipates a 25 percent decrease in stock price.

Figure 14.1 shows an example of a very good H&S pattern exhibited ...

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