Prior Trend: For the formation of the head and shoulder pattern, the prior trend must be bullish.
Left Shoulder: In an uptrend, the left shoulder forms a peak that marks the high point of the current trend, and then starts correcting, which drags the price down. Thereafter, the price finds support at lower levels and starts rising again towards the north.
Head: From the low of the left shoulder, an advance begins that exceeds the previous high(left shoulder) and marks the higher top of the head, which must be at least two times vertically higher than the left shoulder. After peaking, the selloff takes the price down towards the low (Support) point from where head formation had started. Thereafter, any pullback from that support confirms the Head formation. If price does not take support and keeps on plunging down, then the head formation gets violated.
Right Shoulder: A pullback from the low of the head initiates the formation of a right shoulder, which gets completed if the price takes resistance upside, makes the lower peak and starts coming down to test the low (support) made by the head. This peak must be lower than the one made in head formation.
Neckline: The neckline is formed by joining two low points. The first low point marks the end of the left shoulder and the beginning of the head. The second low point marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal. The slope of the neckline will affect the pattern's degree of bearishness. A downward slope is more bearish than an upward slope. The Head and Shoulders pattern is not complete unless the neckline support is broken. Ideally, this should also occur in a convincing manner, with an expansion in volume.
Volume: Volumes play a crucial role in adding significance to reliability of the signal. There are some volume indications which should be verified before implementing the trading strategy. These being:
High volume on the first peak (Left Shoulder)
Moderate volume on the middle peak (Head)
Low volume on the third peak (Right Shoulder)
A sharp increase in volume on the neckline breakout.
Also, once neckline support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break, and offer a second chance to sell.
Price Target: After breaking the neckline , the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a lower price target. Any price target should serve as a rough guide and other factors should be considered as well. These factors might include previous support levels, Fibonacci retracement or long-term moving averages.
Stoploss: After neckline breakout, the stoploss for any trading short position should be put around the high made by the right shoulder. It's always advisable to book the losses as and when prices surpass the high made by the right shoulder.
Fortunately for keen students, a Head and Shoulders Pattern has recently appeared on the daily Sensex charts. The pattern started constructing post the election results . Thereafter, it took almost one and a half months to complete the structure of a bearish head and shoulder pattern. On July 6, the pattern got confirmed when the neckline support of 14,200 was broken decisively.
The approximate target of the formation comes around 12,250 in the Sensex, which is around 14 per cent lower from the breakout point. You may now observe whether the target is reached or not in the ensuing future.
The writer is director and head of research, Anagram Capital.