2 Candlestick Patterns/Head and Shoulders

                                 Head and Shoulders

http://www.finvids.com/Chart-Pattern/Head-And-Shoulders/

Head and Shoulders

The Head and Shoulders top reversal pattern is the best performing chart pattern in a bull market, according to Bulkowski's (2005) research with an averaged maximum decline of 22%. The head and shoulders pattern consists of three "A" peaks, with the first and third peak being roughly equal in height and the second or middle peak being higher than the first and third peaks. A head and shoulder pattern has two armpits or troughs that are low prices between the first shoulder peak and the middle head peak and the middle head peak and the last shoulder peak.

Neckline - Upward Sloping

A line drawn between the two troughs is called the neckline. There are three variations of the head and shoulders pattern as it relates to this neckline: First, if the second trough is higher than the first trough, it is an upward sloping neckline.

Neckline - Downward Sloping

Second, if the second trough is lower than the first trough, then it is a downward sloping neckline; and third and most rarely, when both troughs are even in price it is a horizontal neckline.

Psychology of Head and Shoulders Pattern

The psychology of the head and shoulders pattern is explained next: The head and should pattern occurs during an uptrend, with the left shoulder being yet another higher high for the uptrend. The first trough after the left shoulder is just another expected retracement in an uptrend. From there prices continue the uptrend and make an additional high (creating the head). So far the head and shoulders pattern is not a head and shoulders pattern at all; it is just a higher high, with a short retracement downward and a second higher high in an uptrend. However, problems begin to arise either at the second trough or the right shoulder.
For a downward sloping neckline, the second trough created by the retracement after the head's higher high is far lower than expected. Since the second trough is a lower low and one definition of an uptrend states that prices make higher highs and higher lows, technically the uptrend is over and a new downtrend could be beginning. The right shoulder peak being lower than the head peak confirms the potential end of the uptrend because now there is a lower low and a lower high, one of the main definitions of a downtrend.
However, for an upward sloping neckline head and shoulders pattern, the second trough created by a retracement from the head peak is still a higher low and suggests that the uptrend is still intact. Not until the right shoulder fails to make a higher high do traders begin to worry. When the neckline is broken below on an upward sloping neckline head and shoulders pattern, essentially the upward sloping support line of the prior uptrend has been broken.

Sell Signal and Price Targets

Kirkpatrick and Dahlquist (2010) state that prices breaking through the neckline trigger the sell signal but warn never to trade in anticipation of the neckline breaking sell signal because the "risk of failure is too great"; they also suggest a price target as the height of the pattern (high price of head peak minus lowest of two troughs) subtracted from the breakout price (p. 329). However, Bulkowski (2008) suggests a smaller price target:

Head and Shoulders Breakout Downward Price Target: Breakout Price - ((High Price of Head - Neckline Price) * 55%)