The Basics of the Head and Shoulders Pattern
In terms of technical analysis, the head and shoulders pattern is a predicting chart formation that usually indicates a reversal in the trend where the market makes a shift from bullish to bearish, or vice-versa. This pattern has long been hailed as a reliable pattern that predicts trend reversal. Before we continue, it’s important to keep in mind that the head and shoulders pattern is almost never perfect, meaning, there will likely be small price fluctuations in between the shoulders and the head, and the pattern formation is rarely perfectly shaped in its appearance.
This picture is a clear representation of the three parts of this pattern–two shoulder areas and a head area that the price moves through in creating the pattern signaling a market reversal. The first “shoulder” forms after a significant bullish period in the market when the price rises and then declines into a trough. The “head” is then formed when the price increases again, creating a high peak above the level of the first shoulder formation. From this point, the price falls and creates the second shoulder, which is usually similar in appearance to the first shoulder. Importantly, the initial decline does not carry significantly below the level of the first shoulder before there is usually either a slight retracement upward or a flattening out of price movement.
The Head and Shoulders Inverse Pattern
Head and shoulders patterns can also form in the opposite direction, signaling a market reversal and trend change from bearish to bullish. This is commonly known as an inverse head and shoulders pattern and, simply put, it is essentially the exact opposite of the pattern we just described – or in other words, an upside-down head and shoulders pattern. The inverse pattern is, therefore, a signal that the market is transitioning from a downward trend into an upward trend.
Interpreting the Pattern
The head and shoulders pattern is favored among traders because of its unique ability to help them determine price target estimates once the pattern has completed itself and the neckline has finally been crossed. It also makes it easy for traders to place stop-loss orders. In the case of a peaking head and shoulders pattern, stops are typically placed above the top-of-the-head high price. With an inverse head and shoulders pattern, stops are usually placed below the low price formed by the head pattern.
Using the Pattern to Trade
Before making any trades, it’s important to let a head and shoulders pattern complete itself. If the pattern seems to be forming, or is in the middle of forming, you shouldn’t assume that it will fully develop and make trades based on what you believe is going to happen. The market can be fickle and changes at the drop of a hat, so remember to watch trends as they develop and be patient. Try to avoid getting caught over-anticipating.
The Bottom Line