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Head and Shoulders Pattern: Meaning and Factors
READING
5 mins read
In our previous chapter, we explored in detail the concept of trendlines and their significance in technical analysis. Technical analysts believe historical price data contains valuable information and can predict future price movements with close accuracy.
One way they harness this information is by studying chart patterns, which are repetitive formations that provide insights into potential market trends. Or, you can think of chart patterns as visual representations of price movements that occur repeatedly across various time frames and markets. These patterns are formed by connecting various high and low points, which later act as support and resistance levels. Read more about support and resistance here.
Traders use these patterns to spot entry and exit points, anticipate price targets and identify trends and reversals. Now, there is no guarantee that repetition occurs, but the analysts have much data and research to back their claims.
Amongst many popular chart patterns, the head and shoulder pattern stands out as a widely recognised and influential pattern. It is a bearish reversal pattern, signalling an uptrend's end or a potential downtrend's beginning. In this chapter, we cover in depth what this pattern signifies and how to interpret it!
What Is the Head and Shoulders Pattern?
The head and shoulders pattern is a widely recognised chart pattern used in technical analysis to identify potential trend reversals. It is named after its resemblance to a head, two shoulders and a neckline.
Take a look at the image below –
Now, as you can observe, this pattern will typically occur on an uptrend and signals a possible trend reversal to a bearish direction. Understanding its components, including the left and right shoulders, head, and neckline, is critical to identifying entry and exit points and employing different trading strategies.
Let’s explore each part of Head and Shoulder pattern in detail.
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Left Shoulder:
The left shoulder is the first component of the head and shoulders pattern. It forms when the price reaches a peak during an uptrend, followed by a retracement. The price declines after the left shoulder forms the neckline’s initial support level. The volume is the highest on this shoulder as the uptrend grows stronger. It is essential to observe the left shoulder’s height and volume for confirmation, as they can influence overall pattern reliability and help dodge false signals.
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Head:
The head itself is the central and highest point in the head and shoulders pattern. It represents the peak of the subsequent rally from the left shoulder. The price advance during the head formation is usually higher than the left shoulder, indicating increased buying pressure. Note this: The head’s formation is critical as it establishes the potential resistance level that the subsequent right shoulder must fail to breach.
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Right Shoulder:
Following the formation of the head, there is a subsequent decline in price, creating the right shoulder. The right shoulder is typically lower than the head and exhibits a similar height to the left shoulder. It signifies another attempt by buyers to push the price higher; however, there is a failure in breaching the resistance established by the head. Now, the volume during the right shoulder is the lowest as investor interest decreases or a trend reversal is foreseen.
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Neckline:
The neckline is another crucial element in the head and shoulders pattern and serves as the support level. It connects the lows of the left shoulder, head, and right shoulder. A break below the neckline confirms the pattern’s completion and suggests a high probability of a trend reversal. Traders often look for increased volume on the breakout to confirm the trend reversal.
The distance between the head’s high point and the neckline can provide an estimate of the potential price decline and placement of elements such as target price and stop loss.
How To Interpret Head and Shoulder Patterns?
We have explained the characteristics of the left and right shoulders, head and neckline above. Now, let’s understand how to interpret this pattern with the help of an example. We’ll also show the placement of stop loss and target price calculations.
- Identifying the Head and Shoulders Pattern: Assume a stock X is experiencing an uptrend and moves from ₹75 to ₹100. However, it soon declines back to ₹90. Let us also consider that the volume has significantly increased from the price moved from ₹75 and ₹100. Now, again, assume the price rises from ₹90 to ₹110 and again declines to ₹92. All of these movements will appear like two triangles on the chart. We can then conclude that the left shoulder and a head have been formed, nearly confirming the head and shoulders pattern.
Finally, the price rises from ₹92 to ₹98 and again declines to ₹90, confirming the right shoulder.
Notice the following points –
The highest point in context to the head and two shoulders explained above is ₹110. This becomes or can act as resistance.
The near common point of decline is from the range ₹90 to ₹92. If we roughly join all the low points in the head and left and right shoulders, that leads to the formation of the neckline. This neckline can act as the support. When the neckline is breached, it confirms the completion of the pattern and a potential trend reversal.
Now that we have the pattern and neckline in place, let’s calculate the stop loss and target point.
Stop Loss Placement and Target Price: To manage risk, traders typically place the stop-loss near or above the right shoulder peak point. Let’s say we place the stop loss here at ₹100. If stock X breaches ₹100, it may indicate a failed pattern, and by the placement of stop loss, your position is squared, and you can exit the stock, limiting your losses.
Now, let’s talk about the target price. But what is the target price? It is simply the price you target to book profits before the stock price declines further. It is often determined by measuring the vertical distance between the head and the neckline and subtracting it from the neckline’s breakout level. In our example, the vertical distance is ₹110 - ₹90, i.e. 20.
Now, Target price = Neckline - Height
= 90-20 = 70.
So, what does this mean? It suggests that if the neckline is broken and the head and shoulders pattern is confirmed, then the price can decline up to ₹70.
Factors To Keep in Mind When Trading Head and Shoulders Pattern
When trading the head and shoulders pattern, it is important to consider several factors that can impact trading and the profits you make. These factors are as follows:
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Volume:
Volume is a crucial factor in confirming the validity of the head and shoulders pattern. Typically, higher volume during the left shoulder and head indicates high buying interest and further advancement of the ongoing uptrend. Low buying pressure is typically observed during the right shoulder formation.
Volumes can redirect trends. If there is a high volume during the head, it can falsify the pattern of the head and shoulders as the right shoulder may then not be formed.
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Neckline Break:
The neckline break is the official confirmation of the head and shoulders pattern and also of the trend reversal. The break must be accompanied by significant volume.
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Support and Resistance:
The neckline of the head and shoulders pattern is often treated as a support level, while the peak point of the head is treated as the resistance level. Traders must observe the price behaviour and volume at these points and levels before trading.
Lastly, traders may use additional technical indicators to confirm the pattern and trend reversals.
What Is the Reverse Head and Shoulders Pattern?
The reverse head and shoulders pattern, also known as an inverse head and shoulders is a mirror image of the traditional head and shoulders pattern. It is a bullish pattern that indicates a potential trend reversal from bearish to bullish (while the traditional head and shoulders pattern signals a bearish reversal).
In this, the head peak point is the lowest central point, while the right and left shoulder are formed near the same low points. The neckline connects the highs of the left and right shoulder and the head, and a break above the neckline confirms the pattern.
You can interpret the inverse head and shoulders pattern in a similar manner to the traditional pattern with considerations to volume, neckline breaks and more.
With this, we close this chapter. Remember that reading through trading patterns requires a thorough understanding of technical analysis and its implications. Note that no pattern is foolproof, and it is recommended that you use additional technical indicators to confirm trends and patterns. Also. have a proper risk management strategy in place to minimise losses.
Now, let's move to our next chapter on a different pattern called the double top.