Chart Patterns: Head And Shoulders

Among visual technical analysis tools, the head and shoulders chart 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 bullish or bearish trend reversal.[1] If identified and traded in a consistent fashion, each can be a valuable aspect of any technical trading strategy.

Spotting The Head And Shoulders 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 being the right shoulder and left shoulder of the pattern, and the inner peak is understood as the head. Due to its distinct appearance, it is one of the most highly sought after formations within the realm of forex trading.

One of the pattern's most important levels is the trendline connecting the lowest point of the outer troughs and the base of the head. Normally called the "neckline," it is a vital component of the formation as a whole.

A Bearish Signal?

The standard head and shoulders pattern is considered to be a bearish signal that will precede a definitive downward price trend. However, like all formations, it is not infallible. The presence of a head and shoulders pattern does not guarantee a downtrend developing on futures, forex or stock charts. In most instances, its efficacy may be enhanced by adding other indicators or studies directly to the pricing chart itself. Through combining other tools such as support & resistance levels or momentum oscillators, you may be able to quickly evaluate the pattern's validity.

At its core, 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] Accordingly, the failure to establish a third periodic higher high is indicative of trend exhaustion and a possible reversal.

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How To Trade Head And Shoulders

In the live market, there are many ways to trade the head and shoulders formation. And, one of the pattern's featured benefits is its flexibility. Pragmatically, the head and shoulders pattern may be recognised and traded on any timeframe in any market. So, it doesn't matter if you're buying and selling shares, scalping the U.S. dollar (USD) or day trading the British pound sterling (GBP), the formation is applicable.

A customary manner to trade on the head and shoulders pattern is to observe its completion as the pattern forms through 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.

An increase or decrease in volume is a key foundational element of many pattern-oriented trading strategies. Generally, as traded volumes fall, market conditions become more chaotic. Thus, setups such as the double top or various Japanese candlestick patterns are viewed as getting stronger as volumes grow.

When you quantify the relative levels of volume, you're free to establish stop loss and profit price target locations. Within the context of the head and shoulders formation, this is done in concert with the neckline's location as follows:

  1. After the neckline of the second shoulder formation is broken, you can set a stop loss order at a slightly new low beneath the neckline.
  2. The stop loss below the neckline serves as a protective measure in case a downward breakout is not confirmed and a new high is established.
  3. From there, you can set a profit price target based on the distance from the neckline to the top of the head formation.

Inverted Head And Shoulders

The inverted head and shoulders pattern is the opposite of the head and shoulders. It is characterised by three consecutive price troughs on a chart. Structurally, the outside troughs show roughly the same size and the inner trough falls visibly above the other two. Like the upright head and shoulders formation, 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." Remember, the neckline is a key price target in that it is the basis for stop loss and take profit order locations. The inverse head and shoulders pattern is normally considered to be a bullish signal that will precede a definitive uptrend.

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]

Despite any slight deviations from the norm, each head and shoulder formation consists of a left shoulder, a central peak and a right shoulder. Accordingly, the pattern is not a series of higher highs or lower lows, but an indication that a market is pending reversal or pullback.

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 market correction or pullback. Whereas, its appearance in a longer time horizon may mean there's a trend reversal that extends for a more significant period.[4]

Summary

The head and shoulders is a simple and easily identifiable pattern that has become an essential element in analysts' and traders' toolkits. In the live market, it has established a noted record in helping spot trends and set up trades. When identifying the formation, it's important to keep in mind that the head and shoulders top is the second and highest consecutive peak. Depending on your terminology, the head and shoulders bottom may be the neckline.

While there are other indicators that can suggest pending trends or full-blown reversals, learning how to identify the head and shoulders can give traders a handy visual aid that can be used in both upward spikes and downward price falls. 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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References

1

Retrieved 09 Aug 2016 https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr4.pdf

2

Retrieved 09 Aug 2016 https://www.mta.org/kb/head-and-shoulders-patterns/

3

Retrieved 09 Aug 2016 https://www.aaii.com/computerizedinvesting/article/head-and-shoulders-top-pattern.pdf

4

Retrieved 09 Aug 2016 https://www.cnbc.com/2014/02/10/how-to-use-head-and-shoulder-patterns.html

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