Head and shoulders formation

A sell signal from a head and shoulders formation signals increasing pessimism among investors and the start of a falling trend. Formations like this are considered some of the most reliable formations in technical analysis.

A head and shoulders formation is a top formation which marks the end of a rising period. The formation consists of a left shoulder, a head and a right shoulder, connected by a neckline. The sell signal is triggered when the price breaks downwards through the neckline heading down from the right shoulder.

At the left shoulder, investors are optimistic. The trend is rising and things are looking good for the company. Optimism is reduced when the head is formed. Here the stock might break out from the trend channel and buyers become more passive or sellers more aggressive. At the right shoulder, the optimists are unable to push the price upwards to a new top. Instead sellers push the price downwards through the neckline and a sell signal is triggered.

The stock breaks support at the neckline and a falling trend begins. A stock that has triggered a sell signal from a head and shoulders formation is indicated to continue falling, for at least as long as the formation is high.

Please note that false sell signals from small head and shoulders formations may arise in long term rising trends. Sometimes these can be spotted by a reduction in volume on the break. This indicates little strength in the price movement, and the stock can easily break upwards again and continue the rising trend. In such situations it can be advantageous to keep the stock and wait to see what happens also after the sell signal. This is especially the case if the stock is still in a rising trend or has support from previous bottoms.

Sometimes good indicators of a coming break exist before the neckline is broken. Volume reduction on or towards the top of the right shoulder indicates that the buyers are passive. Increasing volume on the way down from the head or down from the right shoulder indicates that sellers are aggressive. Passive buyers and aggressive sellers are a bad mix and a clear indication of increasing pessimism in the stock and a coming break downward. In such situations it can be advantageous to sell before the sell signal is triggered.