What Is the Head and Shoulders Pattern?
A head and shoulders pattern is used in technical analysis. It is a specific chart formation that predicts a bullish-to-bearish trend reversal. The pattern appears as a baseline with three peaks, where the outside two are close in height, and the middle is highest.
The head and shoulders pattern forms when a stock's price rises to a peak and then declines back to the base of the prior up-move. Then, the price rises above the previous peak to form the "head" and then declines back to the original base. Finally, the stock price peaks again at about the level of the first peak of the formation before falling back down.
The head and shoulders pattern is considered one of the most reliable trend reversal patterns. It is one of several top patterns that signal, with varying degrees of accuracy, that an upward trend is nearing its end.
Key Takeaways
- A head and shoulders pattern is a technical indicator with a chart pattern of three peaks, where the outer two are close in height, and the middle is the highest.
- A head and shoulders pattern—considered one of the most reliable trend reversal patterns—is a chart formation that predicts a bullish-to-bearish trend reversal.
- An inverse head and shoulders pattern predicts a bearish-to-bullish trend.
- The neckline rests at the support or resistance lines, depending on the pattern direction.
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Understanding the Head and Shoulders Pattern
A head and shoulders pattern has four components:
- After long bullish trends, the price rises to a peak and subsequently declines to form a trough.
- The price rises again to form a second high substantially above the initial peak and declines again.
- The price rises a third time, but only to the first peak level, before declining again.
- The neckline, drawn at the two troughs or peaks (inverse).
The first and third peaks are the shoulders, and the second peak forms the head. The line connecting the first and second troughs is called the neckline.
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Inverse Head and Shoulders
The opposite of a head and shoulders chart is the inverse head and shoulders, also called a head and shoulders bottom. It isinverted with the head and shoulders bottoms used to predict reversals in downtrends. This pattern is identified when the price action of a security meets the following characteristics:
- The price falls to a trough, then rises
- The price falls below the former trough, then rises again
- The price falls again but not as far as the second trough
- Once the final trough is made, the price heads upward toward the resistance (the neckline) found near the top of the previous troughs.
An inverse head and shoulders pattern is also a reliable indicator, signaling that a downward trend is about to reverse into an upward trend. In this case, the stock's price reaches three consecutive lows, separated by temporary rallies.
Of these, the second trough is the lowest (the head), and the first and third are slightly shallower (the shoulders). The final rally after the third dip signals that the bearish trend has reversed, and prices are likely to keep rallying upward.
What Does the Head and Shoulders Pattern Tell You?
The head and shoulders pattern indicates that a reversal is possible. Traders believe that three sets of peaks and troughs, with a larger peak in the middle, means a stock's price will begin falling. The neckline represents the point at which bearish traders start selling.
The pattern also indicates that the new downward trend will likely continue until the right shoulder is broken—where prices move higher than the prices at the right peak.
Advantages and Disadvantages of the Head and Shoulders Pattern
Advantages
Experienced traders identify it easily
Defined profit and risk
Big market movements can be profited from
Can be used in all markets
Disadvantages
Novice traders may miss it
Large stop loss distances possible
Unfavorable risk-to-reward possible
Advantages Explained
- Experienced traders identify it easily: The pattern is very recognizable to an experienced trader.
- Defined profit and risk: Short and long entry levels and stop distance can be clearly defined with confirmation openings and closings.
- Big market movements can be profited from: The timeframe for a head and shoulders pattern is fairly long, so a market can move significantly from entry to close price.
- Can be used in all markets: The pattern can be used in forex and stock trading.
While traders agree that the pattern is a reliable indicator, there is no guarantee that the trend will reverse as indicated.
Disadvantages Explained
- Novice traders might miss it: The head and shoulders pattern may not present with a flat neckline; it may be skewed, which can throw off new traders.
- Large stop loss distances possible: Large downward movement over long timeframes can result in a large stop distance.
- Neckline can appear to move: If the price pulls back, the neckline might be retested, confusing some traders.
What Does a Head and Shoulders Pattern Tell You?
The head and shoulders chart is said to depict a bullish-to-bearish trend reversal and signals that an upward trend is nearing its end. Investors consider it to be one of the most reliable trend reversal patterns.
How Reliable Is a Head and Shoulders Pattern?
The most common entry point is a breakout of the neckline, with a stop above (market top) or below (market bottom) the right shoulder. The profit target is the difference between the high and low with the pattern added (market bottom) or subtracted (market top) from the breakout price. The system is not perfect, but it does provide a method of trading the markets based on logical price movements.
Can Head and Shoulders Turn Bullish?
An inverse head and shoulders, also called a "head and shoulders bottom," issimilar to the standard head and shoulders pattern but inverted, with the head and shoulders top used to predict reversals in downtrends.It is a bearish-to-bullish indicator.
What Is the Opposite of a Head and Shoulders Pattern?
The inverse head and shoulders pattern is the opposite of the head and shoulders, indicating a reversal from a bearish trend to a bullish trend.
The Bottom Line
The head and shoulders is a pattern used by traders to identify price reversals. A bearish head and shouders has three peaks, with the middle one reaching higher than the other two. It indicates a reversal of an upward trend.
A bullish head and shoulders has three troughs, with the middle one reaching lower than the other two. It indicates a reversal of a downward trend.
