You might start hearing a lot on the financial channels about something called a head and shoulders pattern. We’ve been talking about it for the last month in our weekly Market Watch newsletter. Unfortunately, our prediction has come to pass, and stocks could be in for a rough stretch.
The Head and Shoulders Pattern Explained
The head and shoulders pattern is a popular technical analysis pattern used by traders and analysts to identify potential trend reversal points in a price chart. It is considered a reliable pattern and is used in both bullish (upward) and bearish (downward) markets. The pattern consists of three peaks or troughs and is named for its visual resemblance to a head and shoulders.
Here are the key components of the head and shoulders pattern:
- Left Shoulder: This is the first peak or trough in the pattern. In an inverted head and shoulders (bullish), it’s a trough, and in a regular head and shoulders (bearish), it’s a peak. The left shoulder is typically formed as a part of the existing trend.
- Head: The head is the central and highest peak or trough in the pattern. In an inverted head and shoulders, this is a peak, and in a regular head and shoulders, it’s a trough. The head is usually higher (inverted) or lower (regular) than the left shoulder, indicating a potential trend reversal.
- Right Shoulder: The right shoulder is the third and final peak or trough in the pattern. In an inverted head and shoulders, it’s a trough, and in a regular head and shoulders, it’s a peak. The right shoulder is typically lower (inverted) or higher (regular) than the head.
To use the head and shoulders pattern for trading decisions, here’s a step-by-step approach:
- Identification: Start by identifying the left shoulder, head, and right shoulder on the price chart. Look for a clear and distinct pattern.
- Neckline: Draw a horizontal line called the neckline that connects the low points of the left shoulder and the right shoulder (for regular head and shoulders) or the high points of the left shoulder and right shoulder (for inverted head and shoulders). The neckline serves as a crucial level of support or resistance.
- Confirmation: Wait for confirmation that the pattern is valid. This can include a break below (for regular head and shoulders) or above (for inverted head and shoulders) the neckline. The volume often plays a significant role in confirming the pattern; higher volume on the breakout is considered more reliable.
- Price Target: To estimate the price target, measure the vertical distance from the head to the neckline and then extrapolate that distance from the breakout point. For example, if the head-to-neckline distance is $10, and the breakout occurs at $50, the price target would be $40 ($50 – $10) for a regular head and shoulders.
- Stop-Loss: Implement a stop-loss strategy to manage risk. Place a stop-loss order below the neckline for a regular head and shoulders or above the neckline for an inverted head and shoulders.
- Trade Execution: Execute your trade when the breakout and confirmation occur, and the risk-reward ratio is favorable.
The head and shoulders pattern is significant because it often marks major trend reversals, whether from bullish to bearish or vice versa. However, like any technical analysis pattern, it’s not foolproof and should be used in conjunction with other indicators and analysis techniques to make informed trading decisions. Traders should also be cautious of false breakouts and use risk management strategies to protect their capital.