If there’s one thing that’s certain about the stock market, it is that the prices of stocks will always rise and fall and rise again. The increase or decrease in stock and security prices may be minor or monumental, but the constant flux is an undeniable aspect of the markets. Traders need to constantly be on the lookout for any potential trend reversals. Today, many technical indicators and chart patterns make this possible. The head and shoulders pattern is one such reliable indicator of an imminent reversal from a bullish to a bearish trend.
What is the head and shoulders pattern?
A head and shoulders pattern is a technical analysis indicator that helps investors identify a potential trend reversal. It is a bearish reversal chart pattern, which indicates that the stock is likely to stop its bullish trend and enter a bearish trend, where the stock price will fall from the current levels. The pattern consists of three peaks: the middle peak (the "head") is higher than the two outside peaks (the "shoulders").
The head and shoulders pattern is formed when the stock price reaches its peak after increasing for a while and then falls down to the base of the prior up-move. Afterwards, the stock price rises higher than the previous peak price to form the pattern’s ‘head’ and then falls back to the initial base. Lastly, the stock price reaches the peak once again around the first peak’s level and falls back down, making the ‘shoulder’ of the chart pattern.
The head and shoulder pattern is considered one of the most trustworthy and reliable chart patterns that indicates a shift from the current uptrend to a downtrend. Investors can use the head and shoulder pattern to either book profits at the current levels for existing stocks or wait for the price to go down to make a fresh entry.
How does the head and shoulders chart pattern work?
In a typical head and shoulders stock pattern, the price of a stock rises to form the first peak. Then, it falls to the base or the neckline before rising past the first peak to form the second peak (or the head). After this, the price declines again to the neckline before rising to form the third peak. From here, it falls steeply below the neckline, indicating a reversal from a bullish to a bearish trend.
Interpreting the head and shoulders pattern
To break it down, there are four components to the head and shoulders pattern:
- The left shoulder: Here, the prevailing buying pressure is temporarily quelled by the selling pressure.
- The head: Here, the buying pressure increases once more and surpasses the earlier peak before the selling pressure takes over.
- The right shoulder: Here, buyers drive the price up once more, but the price eventually fails to rally to its previous peak.
- The neckline: This is the support level below which the price falls at the end of the third peak — confirming the bearish reversal.
Also read: What is Intraday Chart Patterns
What does the head and shoulders pattern tell you?
The head and shoulders pattern is a trend reversal pattern that forms at the end of an uptrend. It indicates that the previous bullish trend is losing momentum, and a bearish trend is likely to start. The pattern suggests that the forces driving the price higher are weakening, and the share price is likely to fall as selling pressure increases due to a sell-off. The stock price’s initial rise to form the left shoulder indicates that there is continued buying interest, and the uptrend is likely to continue. However, the following decline in price indicates that the selling pressure is increasing, and more buyers are becoming sellers to book profits.
The head and shoulders pattern is considered one of technical analysis's most reliable reversal patterns. When confirmed, it provides a strong signal that the current trend is about to reverse, making it a valuable tool for investors and traders looking to buy or adjust their current investments. Investors and traders can identify the head and shoulders pattern and wait for the price to go down to buy at a lower price. If they have current investments, they can book profits to avoid making losses when the price goes down.
The inverse head and shoulders pattern
Similar to how the head and shoulders stock pattern confirms a bearish reversal, its inverse pattern signals a bullish reversal. The inverse head and shoulders pattern is simply the regular pattern turned upside down. So, it consists of three troughs, where the central trough is deeper than the other two. There is also a neckline that indicates the resistance level.
Let’s break down the inverse head and shoulders pattern to interpret it better. It consists of the following components:
- The left shoulder: This is the first trough where the existing selling pressure temporarily gives in to the buying pressure.
- The head: This is the second (and the deepest) trough, which dips past the earlier trough because the selling pressure increases again before the buying pressure takes over.
- The right shoulder: This is the third trough where the sellers drive the price down again, but it fails to drop as low as the second trough and eventually rallies upward instead.
- The neckline: This is the resistance level above which the price breaks out at the end of the third trough — confirming the bullish reversal.
Advantages
Here are the advantages of the head and shoulders pattern for investors and traders analysing stocks through technical analysis:
1. Experienced traders identify it easily
One of the significant advantages of the head and shoulders pattern is that it is relatively easy for experienced traders to recognise. This pattern's distinct shape makes it stand out.
2. Defined profit and risk
The pattern provides clear points for entry (typically below the neckline) and exit (target price), which allows traders to set defined profit and risk levels.
3. Big market movements can be profited from
When a head and shoulders pattern completes and signals a reversal, it often leads to significant price movements. Traders can potentially profit from these substantial market swings.
4. Can be used in all markets
The head and shoulders pattern is not limited to a specific market or asset class. It can be applied to stocks, forex, commodities, and various other financial instruments, making it versatile for traders in different markets.
Disadvantages
Listed below are some disadvantages of the head and shoulders pattern for investors and traders looking to analyse stocks based on the chart pattern:
1. Novice traders may miss it
While experienced traders can readily identify the head and shoulders pattern, novice traders may struggle to recognise it or may misinterpret other price formations as similar patterns. This can lead to missed trading opportunities or incorrect decisions.
2. Large stop-loss distances possible
A significant drawback of trading the head and shoulders pattern is that stop-loss orders may need to be set at relatively large distances from the entry point. This can result in higher risk if the price moves against the trade, potentially leading to more substantial losses.
3. Unfavourable risk-to-reward possible
The pattern's clear entry and target points can sometimes lead to anunfavourable risk-to-reward ratio. In some cases, the potential reward may not justify the risk, particularly if stop-loss levels are set far from the entry point. This can make it challenging to maintain afavourable risk management strategy.
Additional read:What is Hammer Candlestick Pattern
How to confirm the signals offered by the head and shoulders pattern?
You can confirm the reversal indicated by the head and shoulders share pattern using the trading volume and the time frame. Here’s how.
1. Volume confirmation
Check if the trading volume decreases when the price moves up towards the head and right shoulder but increases as the price falls past the neckline. This indicates reduced buying interest and increasing selling interest.
2. Time frame confirmation
The time frame of the bullish trend that precedes the head and shoulders pattern must be at least twice as long as the time frame over which the pattern occurs. This signals a strong trend leading into the pattern, making the reversal more significant for traders.
Top reasons the head and shoulders pattern can be a reliable reversal indicator
There are many indicators for trend reversal in the market. However, the head and shoulders pattern is generally more reliable than many others for the following reasons.
- It occurs over multiple trading sessions, so there is ample time to confirm a reversal.
- It has a clear and defined structure that is easy to recognise for traders in different market segments.
- It can also be confirmed using volume indicators, improving its reliability.
- The shoulder-head-shoulder pattern accounts for traders’ sentiments by reflecting the shifts in bullish and bearish momentum.
- It gives traders entry and exit signals, making it easier to set profit and stop-loss limits.
How to trade using head and shoulders pattern?
The head and shoulders pattern is considered to be one of the ideal technical indicators that indicate that the current bullish trend is likely to end, and the stock price will fall as the selling pressure rises. Once you identify the head and shoulders pattern, you can follow the below steps to trade:
- Identification:The first step is effectively identifying the head and shoulders pattern. Ensure that the pattern is perfectly formed and has all three peaks: the left shoulder, the higher head, and the right shoulder. The neckline should also be clear, connecting the lows between the shoulders and the head.
- Neckline break: The most important step in pattern formation is the neckline break when the price breaks below the neckline. It is important to enter the trade only after the neckline break, as entering a trade before it may be highly risky.
- Entering trade: When the price closes below the neckline, enter a short position or sell, exiting a long position. Investors with a high-risk tolerance can enter trades right after the formation of the right shoulder as they may anticipate the neckline break.
- Setting stop loss:Placing a stop loss is vital, as trading using the head and shoulders pattern can be risky. Ideally, you should put a stop-loss above the right shoulder, as this can be an ideal resistance price level. If you have a lower risk tolerance, you can put a closer stop-loss just above the neckline if you have entered the trade after the break.
- Profit target:To make better trades using the head-and-shoulders pattern, it is important to set a profit target beforehand. You can determine an ideal profit target by measuring the distance from the top of the head to the neckline. Once done, subtract this distance from the neckline breakpoint to set your profit target. Exit the trade when the price reaches the calculated target to realise profits.
Conclusion
You may find it easier to identify a head and shoulders share pattern or its inverse with the details outlined above. Utilise the volume and time frame indicators to confirm the strength of the trendreversal before you make trading decisions based on the head and shoulders pattern.
