What are The Head and Shoulders Chart Patterns. The Head & Shoulders Chart Pattern is one of the most popular and reliable chart patterns in technical analysis, where the pattern looks like a head with two shoulders. Like the double top. the head and shoulders is a reversal pattern that signals the security is likely to move against the previous trend. There are two versions of the head-and-shoulders pattern. The head-and-shoulders top is a signal that a security's price is set to fall, once the pattern is complete, and is usually formed at the peak of an up trend. The second version, the reverse head-and-shoulders (also known as inverse head and shoulders, or head and shoulders bottom), signals that a security's price is set to rise and usually forms during a down trend. Both of these head and shoulders have a similar construction in that there are four main parts to the head-and-shoulder chart pattern: two shoulders, a head and a neckline. The patterns are confirmed when the neckline is broken, after the formation of the second shoulder. The psychology of traders represented in the head and shoulders pattern is similar to that of the double top, in that bulls and bears struggle for supremacy at different price levels. As with the double top volume and the price target play a large part in this struggle between the psychological mindset of buyers and sellers. We will look at each part below with some examples. The head and shoulders are sets of peaks and troughs and the neckline is a level of support or resistance. The head and shoulders pattern is based on Dow Theory's peak-and-trough analysis. An upward trend, for example, is seen as a period of successive rising peaks and rising troughs. A downward trend, on the other hand, is a period of falling peaks and troughs. The head-and-shoulders pattern illustrates a weakening in a trend where there is deterioration in the peaks and troughs and eventually a reversal. Head and Shoulders Top (Reversal) S&P 500 Head and Shoulders Top (Reversal) Example This pattern has four main steps for it to complete itself and signal the reversal. The first step is the formation of the left shoulder (mid Feb 2011), which is formed when the security reaches a new high and retraces lower. The second step is the formation of the head (start of May 2011), which occurs when the security reaches a higher high, then retraces back forming a lower low (breaking the trend). If the second trough is not below the first trough, then this could indicate a reversal isn't about to happen yet, but not always - a technically strong head-and-shoulders top should have a horizontal or down-trending neckline. The third step is the formation of the right shoulder (Jul 2011), which is formed with a high that is lower than the high formed by the head and is again followed by a retracement back to the low of the left shoulder. Ideally the right shoulder should be in line with the first shoulder, as per our example at about $1345, but it's not necessary. The pattern is complete once the price falls below the neckline, which is a support line formed by the troughs. Here bears take control having taken the psychological edge. The support break indicates a new willingness to sell at lower prices. Lower prices combined with an increase in volume indicate an increase in the willingness to sell at these prices - the supply demand dynamic has significantly changed (see The Price, Volume, Supply & Demand Relationship for more on supply and demand). The combination can be lethal, and sometimes, there is no second chance return to the support break. The Importance of Volume As with the double top pattern, volume is an important indicator in playing the head and shoulders pattern. It gives traders an idea of the pattern's strength and potential reversal. Ideally, but not always, volume during the advance of the left shoulder should be higher than that of the advance of the head. The advance of the right shoulder should have even less volume than both the advance to the head or first shoulder. So, volume declines going into the peaks (except for first shoulder), but just as importantly it increases as price declines going into the troughs. The vertical lines in our S&P example show this in action. Final confirmation comes when volume further increases during the decline of the right shoulder. Volume will peak when the neckline is beached, which is by far the most important area to watch in terms of volume. If the volume is lighter on the neckline break, the chances of the price moving back to the neckline after breaking is greater than if the neckline break was accompanied by large volume. Look how volume increases in our S&P example on the price decent from the right shoulder and peaks on the break. Key Features of The Head and Shoulders Pattern Below I've highlighted some key points of the head and shoulders chart pattern. They are for guidance only and shouldn't be seen as gospel:
Trading the Head and Shoulders Top Once the pattern has been confirmed and we've decided to trade, a price target should be set. In our weekly S&P 500 chart our price target on the break will be equal to the distance between the peak of the head to the neckline - In this case $1365 - $1272 = $93. The break occurs at $1262, so our target is $1262 minus $93 = $1169 (Typo of 1170 in the above chart). See how the weekly candle hits this price target exactly, before retracing a little. It's as if all traders have this target in mind. We could have entered our trade either on the break, on the close of the 1st day that breaches the neckline, on a full daily candle below the neckline, or maybe 2-3% under the neckline. It all depends on your threshold for risk. Let's say we enter the trade on a full daily candle below the neckline. As this is a weekly chart we can't see that particular close level, but it was $1260. Our profit before fees is £1260 minus $1169 = $90. price As with all targets other technical analysis factors should be looked at particularly other support and resistance levels that may interrupt our target. I.e. our target of $1169 may have been under an important support level of $1190 making it harder to achieve the $1169 price target - It's just something to look out for. Head & Shoulders Bottom (Reversal) The Head and Shoulders bottom is the exact opposite of the head and shoulders top. It a bullish reversal pattern that forms after a down trend and relies on volume to confirm the pattern is taking place. All the features from the head and shoulders top apply here too, but reversed. I.e. Volume on the troughs must be declining and on the peaks increasing. Ideally the neckline should be horizontal or sloping upwards to show a reversal conviction. The key features of the head and shoulders bottom are:
Analysis of the Head and Shoulders Bottom should focus on correct identification of neckline resistance and volume patterns. These are two of the most important aspects to a successful read, and by extension a successful trade. The neckline resistance breakout combined with an increase in volume indicates an increase in demand at higher prices. Buyers are exerting greater force, and the price is being affected. As seen from the examples, traders do not always have to chase a stock after the neckline breakout. Often, but certainly not always, the price will return to this new support level and offer a second chance to buy. Measuring the expected length of the advance after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds over time, other aspects of the technical picture are likely to take precedent. Technical analysis is dynamic, and your analysis should incorporate aspects of the long-, medium- and short-term picture. |
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What are The Head and Shoulders Chart Patterns. The Head & Shoulders Chart Pattern is one of the most popular and reliable chart patterns in technical analysis, where the pattern looks like a head with two shoulders. Like the double top. the head and shoulders is a reversal pattern that signals the security is likely to move against the previous trend. There are two versions of the head-and-shoulders pattern. The head-and-shoulders top is a signal that a security's price is set to fall, once the pattern is complete, and is usually formed at the peak of an up trend. The second version, the reverse head-and-shoulders (also known as inverse head and shoulders, or head and shoulders bottom), signals that a security's price is set to rise and usually forms during a down trend. Both of these head and shoulders have a similar construction in that there are four main parts to the head-and-shoulder chart pattern: two shoulders, a head and a neckline. The patterns are confirmed when the neckline is broken, after the formation of the second shoulder. The psychology of traders represented in the head and shoulders pattern is similar to that of the double top, in that bulls and bears struggle for supremacy at different price levels. As with the double top volume and the price target play a large part in this struggle between the psychological mindset of buyers and sellers. We will look at each part below with some examples. The head and shoulders are sets of peaks and troughs and the neckline is a level of support or resistance. The head and shoulders pattern is based on Dow Theory's peak-and-trough analysis. An upward trend, for example, is seen as a period of successive rising peaks and rising troughs. A downward trend, on the other hand, is a period of falling peaks and troughs. The head-and-shoulders pattern illustrates a weakening in a trend where there is deterioration in the peaks and troughs and eventually a reversal. Head and Shoulders Top (Reversal) S&P 500 Head and Shoulders Top (Reversal) Example This pattern has four main steps for it to complete itself and signal the reversal. The first step is the formation of the left shoulder (mid Feb 2011), which is formed when the security reaches a new high and retraces lower. The second step is the formation of the head (start of May 2011), which occurs when the security reaches a higher high, then retraces back forming a lower low (breaking the trend). If the second trough is not below the first trough, then this could indicate a reversal isn't about to happen yet, but not always - a technically strong head-and-shoulders top should have a horizontal or down-trending neckline. The third step is the formation of the right shoulder (Jul 2011), which is formed with a high that is lower than the high formed by the head and is again followed by a retracement back to the low of the left shoulder. Ideally the right shoulder should be in line with the first shoulder, as per our example at about $1345, but it's not necessary. The pattern is complete once the price falls below the neckline, which is a support line formed by the troughs. Here bears take control having taken the psychological edge. The support break indicates a new willingness to sell at lower prices. Lower prices combined with an increase in volume indicate an increase in the willingness to sell at these prices - the supply demand dynamic has significantly changed (see The Price, Volume, Supply & Demand Relationship for more on supply and demand). The combination can be lethal, and sometimes, there is no second chance return to the support break. The Importance of Volume As with the double top pattern, volume is an important indicator in playing the head and shoulders pattern. It gives traders an idea of the pattern's strength and potential reversal. Ideally, but not always, volume during the advance of the left shoulder should be higher than that of the advance of the head. The advance of the right shoulder should have even less volume than both the advance to the head or first shoulder. So, volume declines going into the peaks (except for first shoulder), but just as importantly it increases as price declines going into the troughs. The vertical lines in our S&P example show this in action. Final confirmation comes when volume further increases during the decline of the right shoulder. Volume will peak when the neckline is beached, which is by far the most important area to watch in terms of volume. If the volume is lighter on the neckline break, the chances of the price moving back to the neckline after breaking is greater than if the neckline break was accompanied by large volume. Look how volume increases in our S&P example on the price decent from the right shoulder and peaks on the break. Key Features of The Head and Shoulders Pattern Below I've highlighted some key points of the head and shoulders chart pattern. They are for guidance only and shouldn't be seen as gospel:
Trading the Head and Shoulders Top Once the pattern has been confirmed and we've decided to trade, a price target should be set. In our weekly S&P 500 chart our price target on the break will be equal to the distance between the peak of the head to the neckline - In this case $1365 - $1272 = $93. The break occurs at $1262, so our target is $1262 minus $93 = $1169 (Typo of 1170 in the above chart). See how the weekly candle hits this price target exactly, before retracing a little. It's as if all traders have this target in mind. We could have entered our trade either on the break, on the close of the 1st day that breaches the neckline, on a full daily candle below the neckline, or maybe 2-3% under the neckline. It all depends on your threshold for risk. Let's say we enter the trade on a full daily candle below the neckline. As this is a weekly chart we can't see that particular close level, but it was $1260. Our profit before fees is £1260 minus $1169 = $90. price As with all targets other technical analysis factors should be looked at particularly other support and resistance levels that may interrupt our target. I.e. our target of $1169 may have been under an important support level of $1190 making it harder to achieve the $1169 price target - It's just something to look out for. Head & Shoulders Bottom (Reversal) The Head and Shoulders bottom is the exact opposite of the head and shoulders top. It a bullish reversal pattern that forms after a down trend and relies on volume to confirm the pattern is taking place. All the features from the head and shoulders top apply here too, but reversed. I.e. Volume on the troughs must be declining and on the peaks increasing. Ideally the neckline should be horizontal or sloping upwards to show a reversal conviction. The key features of the head and shoulders bottom are:
Analysis of the Head and Shoulders Bottom should focus on correct identification of neckline resistance and volume patterns. These are two of the most important aspects to a successful read, and by extension a successful trade. The neckline resistance breakout combined with an increase in volume indicates an increase in demand at higher prices. Buyers are exerting greater force, and the price is being affected. As seen from the examples, traders do not always have to chase a stock after the neckline breakout. Often, but certainly not always, the price will return to this new support level and offer a second chance to buy. Measuring the expected length of the advance after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds over time, other aspects of the technical picture are likely to take precedent. Technical analysis is dynamic, and your analysis should incorporate aspects of the long-, medium- and short-term picture. |
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