A head and shoulders pattern on a graph represents a series of stock or commodity activities that can denote either an upward or downward trend in price. These fluctuations, when depicted in graph form, roughly trace out the shape of a head and shoulders. Take a look at the example of a head and shoulders pattern on the graph example below:
Image © Investopedia
There are two types of head and shoulder patterns, and both are shown in the image above. We'll get to the types in a moment, but first the basics.
Let's concentrate on the left side of the illustration above first. The left “shoulder” is formed when prices trend upward, peaking at the top of the shoulder. A natural market reaction by investors creates a downward trend, creating the rest of the shoulder. A stronger rally follows this, creating the “head,” with a similar downward trough forming shortly thereafter. Finally, a secondary rally lifts the price and moderates it downward again, forming the right “shoulder.” Once the pattern is complete, analysts will draw a horizontal line through the bases of the head and shoulders; this is called the “neckline.” This represents what is called the “support level” of the stock or commodity, and is often the level at which many investors choose to buy. It's only considered a head and shoulders trend line when both the base of the left and right shoulders both break through the neckline, in either an upward or downward direction.
That brings us to the next topic we'd like to discuss: what's the difference between the two halves of the graph shown above? Well, there are two types of head and shoulder patterns, and they are as follows:
The left side of the illustration shows what is known as a Head and Shoulders Top formation. They are shown “right side up” if you were looking at a human body, with the head peaking above the shoulders. The head and shoulders top formation, once fully formed, indicates an overall drop in price. Yes, the head and shoulders show momentary rallies upward, but once the lower part of the right shoulder drops past the neckline, an analyst can conclude the price is trending downward. This trend represents a “bear,” or downward, market in miniature.
On the right of the example above is shown the Head and Shoulders Bottom, or Inverted, formation, in the form of a human bust shown upside-down. As you might expect, it represents the opposite of a head and shoulders top trend line, and a rise in the price of a stock or commodity over time. As investors react and rally in this situation, the troughs and valleys are formed in the downward direction, but by the time the right shoulder breaks through the neckline, the price is heading upward. The head and shoulders bottom formation, therefore, is an indication of a miniature “bull,” or upward, market trend.
Keep in mind either of these formations can develop in the matter of hours, or they may take days or weeks; a head and shoulders pattern really can't be called that until the market activity it represents is complete. Also, depending on the stock or commodity, top or bottom trends can follow one another in any combination of patterns—but a savvy investor can track them as they form and make buying and selling decisions based on what they see over time. And there's where we come full circle: just as we said at the beginning, wise Bitcoin and other e-currency investing takes place over the long-term, and avoids reactions to momentary fluctuations.
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