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As far as Classic Patterns in technical analysis go, the Head and Shoulders Top formation has got to be one of the most popular and reliable. It is popular because new and seasoned investors can recognize it and reliable because it rarely produces a false positive.

How To Recognize a Head and Shoulders Top Not surprisingly given its name, the Head and Shoulders Top looks like a human head (high rally) with two shoulders (lower rallies). This pattern happens when a rally and subsequent pullback is followed a rally that reaches higher, and then another rally that reaches roughly the same heights as the first rally. These three rallies construct a shoulder, a head, and then another shoulder.

When it comes to technical analysis, a head and shoulders pattern has a volume requirement as well. For the pattern to be legitimate, the first shoulder (rally) will rise on heavier volume than the head and right shoulder.

More Technical Considerations Aside from the easily identified pattern that a head and shoulders top creates after the three rallies and the volume requirement listed above, investors should note that the left and right shoulders will peak at roughly the same price levels. As well, the investor can draw neckline between to the two pullbacks and this can slope upwards or downwards. If that neckline is upward-sloping, then the pattern is considered more bullish than a flat or downward sloping neckline. For a solid bearish trade, confirm a downward sloping neckline.

Investors also need to consider the moving average (MA). The Head and Shoulders Top should occur above an appropriate MA, which is often the 50-day moving average but can also be the 200-day MA for longer patterns. As well, the MA should be trending in the same direction as the head and shoulders pattern. In the event that it does not, then it simply suggests that the head and shoulders top is less reliable.

Trading The Head and Shoulders Top Since this is a bearish pattern, investors are advised to sell their position or take a short position in the underlying security. Investors who look to make trades based on the head and shoulders pattern should understand that the longer it takes for the pattern to develop, the longer it will take for the price to reach its target level. With this in mind, investors should also look at the inbound trend to determine whether it simply a period of consolidation or a legitimate head and shoulders. The rule of thumb here is that the inbound trend is longer than the trend of the pattern itself.

The head and shoulders pattern will form on hundreds of securities daily. The question is not whether the pattern exists, but the reliability and strength of the pattern and whether it is strong enough to trade. Given the knowledge needed to properly identify a head and shoulders top, beginning investors and people who demand a more hands-off approach will opt to use trading software and systems instead.