Head and Shoulders Pattern
A head and shoulders pattern is also a trend reversal formation.
It is formed by a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder). A “neckline” is drawn by connecting the lowest points of the two troughs. The slope of this line can either be up or down. The head is the second peak and is the highest point in the pattern. The two shoulders also form peaks but do not exceed the height of the head. With this formation, we put an entry order below the neckline.
The Head and Shoulders pattern is a popular technical analysis pattern used by traders to identify potential trend reversals in financial markets. It is named for its resemblance to a human head and shoulders and is typically observed in price charts.
Here’s a breakdown of the components of a Head and Shoulders pattern:
1. Left Shoulder: The left shoulder occurs during an uptrend. It’s formed when prices rise to a peak and then decline, forming a temporary trough before rising again.
2. Head: Following the left shoulder, prices rise to a higher peak, forming the head of the pattern. The head is the highest point reached during the uptrend.
3. Right Shoulder: After the formation of the head, prices decline again but typically do not fall as low as the previous trough formed after the left shoulder. This decline is followed by another upward movement, forming the right shoulder.
4. Neckline: The neckline is a trendline drawn across the lows of the left shoulder, the head, and the right shoulder. It acts as a support level. Once the neckline is breached to the downside, it confirms the pattern.
5. Volume: Volume can be a crucial indicator in confirming the validity of the pattern. Typically, volume tends to diminish as the pattern forms, and it may increase when the neckline is breached.
The Head and Shoulders pattern is considered a bearish reversal pattern when it appears at the end of an uptrend. Once the price breaks below the neckline, traders often interpret it as a signal to sell or to anticipate a potential downtrend. However, it’s important to note that not all Head and Shoulders patterns lead to significant reversals, and traders often look for confirmation through other indicators or patterns before making trading decisions.
Conversely, an inverted Head and Shoulders pattern, which forms at the bottom of a downtrend, is considered bullish, with the neckline acting as a resistance level that, once broken, signals a potential uptrend.
As with any technical analysis tool, traders need to consider other factors, such as market context, volume trends, and broader market sentiment, before relying solely on the Head and Shoulders pattern for trading decisions. Additionally, patterns like the Head and Shoulders should ideally be used in conjunction with other technical analysis tools and risk management strategies to make informed trading decisions.