Chart Patterns: Head And Shoulders

Among visual chart patterns, the head and shoulders pattern has gained status among the most reliable predictors of future price action. The head and shoulders and its counterpart, the inverted head and shoulders, are understood to foreshadow a potential trend reversal.1)Retrieved 09 August 2016 https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr4.pdf

Spotting The Pattern

The head and shoulders pattern is characterised by three consecutive price peaks on a chart. The outside peaks show roughly the same size, and the inner peak rises visibly above the other two. Thus, the outer peaks are understood as the shoulders of the pattern, and the inner peak is understood as the head. The trendline connecting the lowest point of the outer troughs and the base of the head is normally called the “neckline.”

The standard head and shoulders pattern is considered to be a bearish signal that will precede a definitive downward price trend. The head and shoulders pattern is understood to represent successive attempts by market participants to buy into a trend. While the price moves higher after the first shoulder with the formation of the head pattern, the failure of the price to move higher on a third consecutive swing is understood as confirmation that the market lacks conviction about the possibility of price to move toward a still higher level.2)Retrieved 09 August 2016 https://www.mta.org/kb/head-and-shoulders-patterns/

How To Trade Head And Shoulders

A customary manner to trade on the head and shoulders pattern is to observe its completion as it moves through the formation of the second shoulder. As with other reversal patterns, traders will want to look for a drop or rise in trading volume to verify a breakout.

After the neckline of the second shoulder formation is broken, a stop order can be set at a level slightly below the neckline. The stop below the neckline serves as a protective measure in case a downward breakout is not confirmed. From there, a profit target can be set based on the distance from the neckline to the top of the head formation.

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Inverted Head And Shoulders

The inverted head and shoulders pattern is the opposite of the head and shoulders, characterised by three consecutive price troughs on a chart: the outside troughs show roughly the same size, and the inner trough falls visibly above the other two. Like upright head and shoulders, the outer troughs are understood to be the shoulders of the pattern and the inner trough is understood as the head.

The trendline connecting the highest point of the outer peaks and the base of the head constitutes the “neckline.” The inverse head and shoulders pattern is normally considered to be a bullish signal that will precede a definitive upward price trend.

Irregular Patterns

The head and shoulders pattern will not always appear to be perfectly symmetrical. At times, the second shoulder formation may be slightly narrower than the first, or it may occur after a compressed or dilated period of time. Similarly, the neckline of the pattern may not occur in a perfectly horizontal position.

On occasion, it can slant on a diagonal upward or downward slope, but the breakout will still be considered to be outside the neckline. For these reasons, it’s important to maintain a keen eye for the formation of the pattern, regardless of potential variations in its basic shape.3)Retrieved 09 August 2016 https://www.aaii.com/computerizedinvesting/article/head-and-shoulders-top-pattern.pdf

Long-Term Reversals And Short-Term Corrections

The head and shoulders pattern can occur in various time frames, so the period over which it occurs can make a difference in what it may be signaling. Traders should note that over a shorter period of time, the appearance of a head and shoulders pattern may be signifying a short-term correction. Whereas, its appearance in a longer time horizon may mean there’s a trend reversal that extends for a more significant period.4)Retrieved 09 August 2016 http://www.cnbc.com/2014/02/10/how-to-use-head-and-shoulder-patterns.html

Summary

The head and shoulders is a simple and easily identifiable pattern that has become an essential element in analysts’ and traders’ toolkits for its noted record in helping spot trends and set up trades. While there are other indicators that can suggest trend reversals, learning how to identify the head and shoulders can give traders a handy visual aid that can be used in both upward and downward price movements. To make effective use of the tool, traders should learn to distinguish the pattern from other formations in varying conditions and time frames.

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