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Table of Contents:
- Identifying head and shoulders pattern
- The three components of a head and shoulders pattern
- Head and shoulders pattern pros and cons
- Head and shoulders trading
- Head and shoulders stock pattern
- The bottom line
One of the strategies investors and analysts use to determine where to invest in the stock market is to study trends and patterns (such as head & shoulders pattern, cup and handle pattern, golden cross pattern, and others) for an apparent price shift. Being able to spot patterns and identify what they mean may improve opportunities for success.
One of the more well-known patterns is called the head and shoulders pattern, which is a price reversal pattern. It’s a technical analysis that, when appropriately identified, can be used as a method of predicting a trend reversal. It may indicate a market shift from bullish to bearish or vice versa, signaling that a trend is coming to an end.
Although the head and shoulders technical analysis pattern, if properly identified, can be a reliable source of information, it’s less than perfect, as the formation can be challenging to spot.
- The head and shoulders pattern is a formation that includes 3 crest points with the 2 side crests (shoulders) even and the middle point (head) sitting higher.
- In technical analysis, it is used to predict trend reversals from bearish to bullish or vice versa.
- Investors consider the head and shoulders chart to be one of the more reliable patterns.
Identifying head and shoulders pattern
There are 3 main components in the formation of the head and shoulders pattern. First, it begins with the price moving up and then dipping slightly to form the left shoulder. Then, as the price rallies, it creates a high point, which is the head of the pattern. Then it drops again, forming the right shoulder. The photo below represents the 3 parts of the head and shoulders pattern as they develop.
Swing lows occur when the price drops, trailing the left shoulder and head. This connects with the trendline that extends to the right and forms the neckline, completing the pattern.
Inverted head and shoulder pattern
An inverse head and shoulder pattern, also known as an upside-down pattern, forms in the opposite direction which signals that the market trend has changed from bearish to bullish. This means it’s shifting from a downward trend to an upward trend.
As the inverted head and shoulders pattern develops, stock prices dip to 3 distinct lows with 2 cycles of upward trends as prices rally. The lowest dip in the inverse pattern signifies the head, while the left and right dips that represent the shoulders are not as significant. As the second shoulder develops, the prices rally for a final time, breaking out above the neckline, signaling the bearish trend has turned to a bullish market.
The three components of a head and shoulders pattern
As discussed, the 3 components of the head and shoulders pattern are the left shoulder, right shoulder, and head. One of the reasons traders like this pattern is that once it’s complete and the neckline has been crossed, it helps them discover price targets and simplifies placing stop-loss orders.
During a high point in the pattern, stops may be placed above the head. With an inverted pattern, stops are placed below the head. To evaluate how significantly prices will shift after the neckline is broken, a vertical measurement of the distance from the top of the head down to the neckline is needed. But in the case of the inverted head and shoulders pattern, you’d measure from the top of the head up to the neckline, which provides insight as to how prices can shift past the neckline.
The neckline is also an essential part of the head and shoulders pattern as it is the level of resistance that traders use in order to establish the area range to place orders. So, to find the neckline, first, locate the left shoulder, head, and right shoulder. Then connect the low points after the left shoulder with the low after the head, which creates the neckline.
The neckline connects the lows and highs to form support and can assist in anticipating bullish and bearish trend reversals. A price break below the neckline of a high can signal that the uptrend is ending, and a transition to a bearish market may be likely. But when a break occurs above the neckline, the bear market trend is likely turning upward to a bullish market.
The neckline isn’t always in a straight horizontal line and may be angled due to varying highs and lows. A significant slope may provide information that the trend is less reliable, and more analysis is needed.
Head and shoulders pattern pros and cons
Although not failproof, the head and shoulders pattern is one of the most popular strategies for a variety of reasons.
Pros of the head and shoulders pattern are:
- It may be easier to identify for experienced traders.
- Risk and profit levels can be defined.
- A potential to benefit from market shifts.
- It can be used in any market.
Cons of the head and shoulders pattern are:
- It can be difficult for beginners to identify the changing trends.
- The price can shift at the neckline, confusing traders with little experience.
- Confirmation may close significantly below the neckline, resulting in a broad stop-loss distance that needs reviewing.
- Risk vs. reward rates may not be beneficial.
As with any investment strategy, watching how patterns form and develop can take time, but even then, it can be tough to identify the patterns. There can also be shifts in the stock market that make hitting your calculated price target very difficult.
Head and shoulders trading
One of the most important points when using the head and shoulder chart pattern is to wait until the pattern is complete. Sometimes the patterns don’t develop entirely—and may never—so it is important to keep watch.
Once the pattern breaks the neckline, the key is to wait for the price to shift lower than the neckline after peaking at the right shoulder. When looking at the inverse head and shoulders, look for when the price moves above the neckline, after the formation of the right shoulder.
The entry point
The most common entry point is when there is a breakout, such as when there is a breaking point from the neckline.
Another option for entry is when an investor waits to see if there is a pullback after the breakout has happened. However, this comes with a possible missed opportunity. If the pullback doesn’t stop and the breakout continues along with the price, the opportunity has been missed.
In a regular head and shoulders pattern, stops are placed above the right shoulder after the breakout from the neckline. In an inverse pattern, it may be placed at the head, which is considered a riskier option.
Setting profit targets
The profit target is the price difference between the head and the low point of either the right or left shoulder. That difference subtracted from the breakout point at its highest level of the neckline provides the target price. The difference would also be added to the neckline breakout price to calculate from a market low. Despite the reliable nature of the head and shoulders pattern, it can take a lot of time and patience to detect a breakout and reach the profit target.
Head and shoulders stock pattern
In the same way that many stock market patterns indicate the sentiment of both bulls and bears and the tug of war that exists among them, the head and shoulders pattern follows suit.
The first spike and following dip can be interpreted as a momentum that is weakening from a bullish trend. Bulls then respond with an effort to push prices upward past the initial crest to form the head as they hold on to control and work to advance the upward trend.
Despite their best efforts, the prices decrease again and move to a point even lower than the original, as bears gain control. But as bulls do, they push ahead but don’t quite reach the peak, landing at a lower point, signifying that the bears are taking over as prices dip, and the trend is reversed. This concludes with the bull’s failed head and shoulders pattern.
The bottom line
One of the benefits of the head and shoulders stock pattern and the reason it is so popular among investors is that it can be used in any market. In addition, the pattern may be more visible and identifiable for experienced traders.