Head and Shoulders Pattern: Explained
Traders and analysts constantly assess stock market patterns and trends to understand the direction of future prices. Spotting and understanding the initiation of an established pattern on the stock charts can help traders make significant profits. The Head and Shoulders pattern formation is one such pattern with a long-standing history of reliability in the stock markets. This article thoroughly studies everything you need to know about a Head & Shoulders pattern.
What is the Head and Shoulders Pattern?
Before we dig deep into the Head and Shoulders pattern, let us understand the concept of trend reversals. Suppose you purchase security moving in the upward direction. As you buy the security, you steadily begin to incur profits. Assume that after a brief upward trend, the stock prices suddenly change their direction and start a steep downward journey. What essentially happened here was the direction of movement of security prices suddenly reversed, a phenomenon also referred to as trend reversal. However, brief upswings and downswings can be caused due to market volatility and may not constitute a trend. For the above instance to qualify as a trend reversal, the securities must continue their downward movement for a specific period.
The Head and Shoulders pattern is an excellent indicator to warn traders of an upcoming trend reversal. The reversal could be due to a shift from a bullish to a bearish swing or vice versa. The three main constituents of the Head and Shoulders pattern are a left shoulder, followed by the formation of a head-like structure, and a right shoulder.
How does the head and shoulder chart pattern work?
The Head Shoulder pattern forms three peaks in the form of two shoulders separated by a head-like structure in between. Let us understand how this pattern forms.
The first shoulder forms due to a bullish trend when prices rise in the current market direction before swinging downward, making a trough. After this, the prices rise again, exceeding the highest point formed from the shoulder-like structure. The head area is where the price moves to the highest level and starts falling. The prices do not decrease below the level of the first shoulder immediately. They follow a retracement at a specific level as they descend downward, leading to what appears as a right shoulder formation.
The pattern also shows the formation of a neckline. The neckline connects a few points during the pattern.
- The first point in creating the neckline is the low price range until which security prices fall while forming the left shoulder. From this point, prices begin to ascend their way up, making a significant head.
- As prices begin to fall from the head-like structure, they again hit a level where they retrace their upward journey. It is the second point in the neckline.
These two points are connected to form a neckline. Both these levels serve as the lowest point until the security prices fall and are also referred to as the support level.
Interpret The Pattern
The Head and Shoulders pattern benefits traders since it helps understand the future price targets as the pattern completes and prices breach the neckline. Traders can also use the pattern to place stop-loss orders.
Let us understand how to interpret the pattern and measure future price targets.
Step 1: To estimate how much security prices will move after breaching the neckline, you must measure the distance from the top of the head-like structure to the neckline.
Step 2: Subtract the same distance from the neckline in the opposite direction, starting with the point where security prices breached the neckline after forming the second shoulder.
Let us understand this with an example. Suppose the distance between the top of the head and the neckline is Rs. 100. Now, when the trend is completed, and prices breach the neckline after forming the second shoulder, they are expected to continue their downward movement for at least another Rs. 100 below the neckline price level.
Volume plays a critical role in analysing the Head and Shoulder pattern. You may use several indicators to measure volume. After the pattern completes upon forming the second shoulder and prices begin to fall, it should also be accompanied by a spike in the volumes. In addition, the volume at the head-like structure should be more than the left and right shoulder.
Explain the Inverse Head and Shoulders Pattern
An inverse Head and Shoulders Pattern also works as a trend reversal indicator. It is a mirror image of a typical Head and Shoulders pattern and indicates a shift from bearish to bullish sentiments. Here, the stock’s price reaches three consecutive lows, separated by temporary rallies.
What is an Inverted Head and Shoulder Pattern?
In a typical inverted Head and Shoulder pattern, security prices experience three dips separated by two temporary periods of increasing prices. The middle trough constitutes the lowest prices, while the shoulders are somewhat deep. After the second shoulder is formed, the prices rally upwards, surpassing the neckline and showing a bullish reversal.
7 Reasons why the head and shoulders pattern is deemed reliable by traders
The Head and Shoulders is a reliable pattern that helps investors select the suitable entry and exit points. Let us understand how.
- Shift in Sentiments -The Head and Shoulders pattern helps investors identify a change in the market sentiments leading to trend reversals. Assessing the pattern can help investors stay ahead of an upcoming trend reversal.
- Future Price Targets -The Head and Shoulders pattern helps investors calculate how much the security prices will move upon trend reversal.
- Stop-loss – After the pattern completes, prices are expected to follow a bearish trend. Traders can place stop-losses a notch above the neckline to ensure they do not incur significant losses in case of trend failure.
- Combined with Other Indicators – You may use the Head and Shoulders pattern in conjugation with various other indicators to better understand the upcoming trend. Some indicators are trendlines, moving averages, support/resistance indicators, and relative strength index.
- Volume provides confirmation – Volume plays a critical role in determining the success of the Head and Shoulder pattern. For instance, during an inverse Head and Shoulders pattern, traders may typically look for more extensive volumes during a breakout, which essentially depicts a more substantial buying interest in the security.
- Beneficial across all markets – The Head and Shoulders pattern is used extensively across various technical charts and is popular in stock market trading.
Identifying trends on technical charts gives a better understanding of the ongoing market direction and helps traders forecast future price movements more efficiently. Identifying a Head & Shoulders pattern is a reliable way of knowing if a trend reversal might be coming up. As a result, traders can design effective trading strategies by inferring Head and Shoulders share price forecasts.