The head and shoulders pattern is a scenario where a peak is between 2 lower peaks. The price of the security is not able to make a high which is higher than the previous high. As such, this is interpreted as a sign of weakness where eventually, the price of the security will fall significantly. Chartists believe that the magnitude of the decline is likely to be at least the difference between the highest peak and the neckline.
The neckline is known as the support level for the security. As the price breaks below the neckline, reversal is confirmed in the form of a free falling price.
What should option traders do in a head and shoulders occurrence?
Option traders that recognize the head and shoulders pattern should exit long positions especially if a profit has already been made. Also, the trader may want to consider initiating a bearish position as the price breaks below the neckline.