How to spot a Head and Shoulders formation:
Left shoulder:The prevailing trend must be that of a bullish one, with the price anticipating its next move around a key level of resistance. Price action may often form a bearish candlestick formation, acting as a catalyst for a deep pullback.
Head: The following wave will continue to rise forming a new high before forming another bearish reversal, leading the new price slightly lower once again. This peak is the highest point in the pattern.
Right shoulder: Finally the price will rise again, but this time it will not exceed the previous high, thus forming a lower high from the head.
Once Head and Shoulders Plays Out:
Once we have correctly established the head and shoulders pattern a 'neckline' is drawn by the connection of the lowest points of the two troughs. It is now possible to anticipate a break to the downside.
Take a look at the example on the following page:
The right shoulder is also known as a lower high, once this is formed and breaks the neckline the price declines. This break and the area of close vicinity below are great selling execution points. If you decide to execute a sell position and take a short trade, an ideal position to place your stop loss would be above the right shoulder.