Head And Shoulders Pattern
What Is a Head And Shoulders Pattern?
A head and shoulders pattern is a chart formation that appears as a baseline with three peaks, the outside two are close in height and the middle is highest. In technical analysis, a head and shoulders pattern describes a specific chart formation that predicts a bullish-to-bearish trend reversal. The head and shoulders pattern is believed to be one of the most reliable trend reversal patterns. It is one of several top patterns that signal, with varying degrees of accuracy, that an upward trend is nearing its end.
KEY TAKEAWAYS
- A head and shoulders pattern is a technical indicator with a chart pattern described by three peaks, the outside two are close in height and the middle is highest.
- A head and shoulders pattern describes a specific chart formation that predicts a bullish-to-bearish trend reversal.
- The head and shoulders pattern is believed to be one of the most reliable trend reversal patterns.
What Is The Head And Shoulders Pattern?
Understanding A Head And Shoulders Pattern
The head and shoulders pattern forms when a stock's price rises to a peak and subsequently declines back to the base of the prior up-move. Then, the price rises above the former peak to form the "nose" and then again declines back to the original base. Then, finally, the stock price rises again, but to the level of the first, initial peak of the formation before declining back down to the base or neckline of chart patterns one more time.
What Does A Head And Shoulders Pattern Tell You?
A head and shoulders pattern is comprised of three component parts:
- After long bullish trends, the price rises to a peak and subsequently declines to form a trough.
- The price rises again to form a second high substantially above the initial peak and declines again.
- The price rises a third time, but only to the level of the first peak, before declining once more.
The first and third peaks are shoulders, and the second peak forms the head. The line connecting the first and second troughs is called the neckline.
An inverse or reverse head and shoulders pattern is also a reliable indicator which can also signal that a downward trend is about to reverse into an upward trend. In this case, the stock's price reaches three consecutive lows, separated by temporary rallies. Of these, the second trough is the lowest (the head) and the first and third are slightly shallower (the shoulders). The final rally after the third dip signals that the bearish trend has reversed and prices are likely to keep rallying upward.
Tug-of-War
Stock prices are the result of a continuous game of tug-of-war; whether a stock's price goes up or down is the direct result of how many people are on each team. Those who believe a stock's price will go up are called bulls, and those who believe the stock will go down are called bears. If more of a stock's shareholders are bears, then its price will go down as they sell their shares to avoid losing money. If more people are bullish, then the price will go up as new investors buy in to take advantage of the opportunity.
Inverse Head And Shoulders
The opposite of a head and shoulders chart is the inverse head and shoulders, also called a head and shoulders bottom, is inverted with the head and shoulders top used to predict reversals in downtrends. This pattern is identified when the price action of a security meets the following characteristics: the price falls to a trough and then rises; the price falls below the former trough and then rises again; finally, the price falls again but not as far as the second trough. Once the final trough is made, the price heads upward, toward the resistance found near the top of the previous troughs.
The Limitations Of Head And Shoulders
Like all charting patterns, the ups and downs of the head and shoulders pattern tell a very specific story about the battle being waged between bulls and bears.
The initial peak and subsequent decline represent the waning momentum of the prior bullish trend. Wanting to sustain the upward movement as long as possible, bulls rally to push the price back up past the initial peak to reach a new high (the head). At this point, it is still possible that bulls could reinstate their market dominance and continue the upward trend.
However, once price declines a second time and reaches a point below the initial peak, it is clear that bears are gaining ground. Bulls try one more time to push price upward but succeed only in hitting the lesser high reached in the initial peak. This failure to surpass the highest high signals the bulls' defeat and bears take over, driving the price downward and completing the reversal.
https://www.investopedia.com/terms/h/head-shoulders.asp
How to Trade the Head and Shoulders Pattern
The head and shoulders chart pattern is a reversal pattern and most often seen in uptrends.
Not only is head and shoulders known for trend reversals, but it’s also known for dandruff reversals as well.
In this lesson, we’ll stick to talking about trend reversals and leave the topic of dandruff for another time.
Head and Shoulders
A head and shoulders pattern is also a trend reversal formation.
It is formed by a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder).
A “neckline” is drawn by connecting the lowest points of the two troughs.The slope of this line can either be up or down. Typically, when the slope is down, it produces a more reliable signal.
In this example, we can easily see the head and shoulders pattern.
The head is the second peak and is the highest point in the pattern. The two shoulders also form peaks but do not exceed the height of the head.With this formation, we put an entry order below the neckline.
We can also calculate a target by measuring the high point of the head to the neckline.
This distance is approximately how far the price will move after it breaks the neckline.
You can see that once the price goes below the neckline it makes a move that is at least the size of the distance between the head and the neckline.
We know you’re thinking to yourself, “the price kept moving even after it reached the target.”
And our response is, “DON’T BE GREEDY!”
Inverse Head and Shoulders
The name speaks for itself. It is basically a head and shoulders formation, except this time it’s upside down.
A valley is formed (shoulder), followed by an even lower valley (head), and then another higher valley (shoulder). These formations occur after extended downward movements.
Here you can see that this is just like a head and shoulders pattern, but it’s flipped upside down.
With this formation, we would place a long entry order above the neckline.
Our target is calculated just like the head and shoulders pattern.
Measure the distance between the head and the neckline, and that is approximately the distance that the price will move after it breaks the neckline.
You can see that the price moved up nicely after it broke the neckline.
If your target is hit, then be happy with your profits.
However, there are trade management techniques where you can lock in some of your profits and still keep your trade open in case the price continues to move your way.
You will learn about those later on in the course.
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