The Head and Shoulders pattern is one of the most reliable technical analysis patterns, yet one of the most misunderstood. This is because most websites propagate the simple, and incorrect, version of the pattern.
Every amateur pundit or self-proclaimed guru trader believes they know what it means and think they understand it, but they do not.
Here we discuss the famous Head and Shoulders price pattern; it has some unique characteristics. However, you do need to know what you are looking for.
Head and Shoulders Stock Pattern Accurately Defined
The Head and Shoulder stock pattern defines a reversal of a stock price trend. It occurs in a price uptrend and has three elements; the left shoulder, the head, and the right shoulder. All three are price peaks, but the head is higher than the shoulders. The pattern is only confirmed with volume.
What most people do not understand is that the price pattern needs to have specific corresponding volume characteristics.
The Head & Shoulders Stock Chart
The three main elements of the head and shoulders stock pattern are shown on this chart.
- The price movement has two shoulders.
- It has a high point, the head, in between the shoulders.
- The volume should confirm the pattern (explained below).
7 Steps To Understand the Head & Shoulders Pattern.
1. The left shoulder has to be formed on increasing volume; this means you have heavy bullish buying into the stock price move.
2. The Head is formed on decreasing volume. This is important because if the head were built on increasing volume, it would simply be a rally continuation.
3. The right shoulder represents a failed rally initially on increasing volume. This means the stock is trying to rally but fails despite the increased volume; then, the stock price starts to fall on decreased volume.
4. The neckline. Using a trend-line, connect the low from both sides of the head through the outer price lines. There you see the distinct pattern above the neckline.
5. The left shoulder is formed on increasing volume. This is to be expected.
6. In the forming of the head, we see a significant decrease in volume.
7. In the right shoulder, we also see the decreasing volume.
What Does a Head & Shoulders Pattern Mean
The Head & Shoulders Pattern is a representation of supply and demand. We see a surge upwards on increased trading volume in the left shoulder, which indicates a bullish bias, meaning more buyers and fewer sellers at this price.
At the head, we see another surge upwards, but this time on decreased volume. The decreased volume is critical, as this means there are fewer market participants interested in buying the stock but even fewer interested in selling it at this price.
As the price declines, it is time for a new rally; however, there are now more sellers than buyers. The sellers sell, and because there are fewer buyers, the sellers sell at a lower price. So, less volume and lower prices.
This indicates that the market will experience a trend reversal from an uptrend to a downtrend.
All of the above conditions of the Head & Shoulders pattern here are consistent with textbook descriptions. See the classic book Technical Analysis of the Financial Markets by John J Murphy as a reference.
The Head and Shoulders pattern is said to be confirmed on a break of the neckline; this is about to occur in the chart above.
Therefore once the neckline is broken, the price declines.
How Far Will the Price Fall: Measure the Distance
In technical analysis, the theory is, if you want to understand how far the price will fall after the stock price reversal is confirmed by the break of the neckline, then you need to measure the distance. The length of the neckline should be roughly proportional to the amount of the drop.
For me, this theory is dubious, as it completely depends on the price scale you are using on the chart.
Inverse Head & Shoulders Pattern
You can exactly use this methodology to define the inverse Head and Shoulders Pattern, which predicts a stock price bottom rather than a top. This reversal formation means you should see a price decrease on lower volume (left shoulder), followed by a price decrease on lower volume (head). Then finally, after a short drop in price, a bottom at higher volume, suggesting the downturn is over, the sellers have all sold, and there are only buyers left in the market to drive up prices.
Use these seven steps to confirm a head and shoulders top and a head and shoulder bottom – it is the key reversal pattern. Because if it is a real market turning point and the market will head downwards, you will want to protect your assets from the crash.
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