Head and Shoulder Pattern – Chart Pattern Analysis: Part 3

Traders and technical analysts are regularly studying charts of different financial assets to understand the trend, various patterns to predict the future movement of price. It is very necessary to understand the formation of different patterns and their result. The Head and shoulder pattern is an important pattern for traders because of its reliability in different financial instruments. It is considered as one of the best patterns to indicate bullish to bearish reversal.

Head and shoulder is a chart pattern that indicates the reversal of the trend where market sentiment changes from bullish to bearish. This is one of the most reliable patterns for the technical analyst to predict trend reversal because of the performance of the pattern in the past. The core structure of head and shoulder patterns are always the same but the formation of the patterns is rarely perfect.

In a head and shoulder pattern, there will be three peaks. Among them, the height of the two peaks will be the same and the middle one will be the highest. In this article, we will talk about the core components of head and shoulder patterns, how to identify them perfectly and how you can take advantage of this pattern in your trading.

Core Components of the Head and shoulder pattern

Uptrend

For a head and shoulder pattern to form there should be a previous uptrend. A bullish impulsive move to the upside will lead to the formation of the pattern.

Left Shoulder

After a strong bullish movement, when the price rises and gets rejected into a trough, it will create the left shoulder of the pattern. At this stage, we don’t have enough points to draw the neckline of the pattern.

Head

After the formation of the first shoulder, when the price increases again and crosses the level of the left shoulder towards the upside and gets rejected again for the second time, it will create the head of the pattern. Head is the highest peak among the three peaks of the pattern. Generally, the highest point of the head will be the top of the uptrend.

Here we have two points to draw the neckline but we need to wait for the completion of the right shoulder.

Right Shoulder

After the formation of the head, price usually drops and tries to rise again. This time the price will get rejected from the left shoulder level and will drop again.

Now we have all three points to draw the neckline of the pattern.

Neckline

The neckline is one of the key components of the pattern which acts as a support zone for all three peaks. Many traders say, it is the line between buyers and sellers.

Head and shoulder Breakout & Neckline Retest

Breakout

When the price crosses the neckline towards the downside, it’s called neckline breakout. After neckline breakout, the validity of the pattern is confirmed. Traders can make their decision based on this pattern after neckline breakout.

But if the price does not cross the neckline, starts to rise again, and crosses the levels of the previous peaks towards the upside, there is a high probability of the continuation of the uptrend. So you have to be careful in this zone and wait for the formation of the perfect pattern.

Neckline Retest

Many traders wait for the retest of the neckline to confirm the validity of the pattern. When the price crosses the neckline towards the downside, many times it again rises to the neckline and gets rejected from the neckline again. Neckline retest gives an extra confluence to the traders because at this stage price declined to rise multiple times.

Reason for forming head and shoulder pattern:

Every chart pattern contains an indication of future price movements. Sometimes they are easy to identify and sometimes they aren’t. The Head and shoulder pattern indicates there is a change in the sentiment of the traders. There aren’t enough people willing to buy the share anymore and that causes the price to get rejected several times.

When a major trend reversal occurs, there are transitions occurring between buyers and sellers. Head and shoulder and different other chart patterns are an outcome of this transition of sentiment and trading decision between buyers and sellers. The Head and shoulder pattern works because of the way the pattern developed with highs and lows at the end of the uptrend.

Reverse Head and Shoulder Pattern:

Head and shoulder patterns can also form in the opposite direction at the end of a downtrend signaling a weakness of the downtrend and a potential trend reversal. The inverse Head and Shoulder pattern looks exactly opposite of the head and shoulder pattern or in other words, it is the upside-down version of the head and shoulder pattern. All the components of an inverse head and shoulder pattern are the same but opposite of the head and shoulder pattern. Inverse Head and Shoulder patterns form when the previous downtrend is getting weaker and after the formation of the pattern, traders are confident about the new start of the uptrend.

The reverse head and shoulder pattern is a very important pattern for the traders because at the end of a downtrend, the price of that stock is significantly lower and it is one of the best positions for a trader to buy that stock. So, whenever they find an inverse head and shoulder pattern is forming, they prepare for the completion of the pattern, wait until the price broke the neckline, and then they buy the shares according to their strategy. If you can identify inverse head and shoulder patterns properly, you can buy shares of various companies at very low prices. So it’s recommended to understand this pattern well for better trading.

Interpreting the pattern:

The Head and shoulder pattern is popular among traders and technical analysts because of the pattern’s ability to predict the price movements of various stocks. This historically proven pattern is used by traders to get an idea about the price target once the formation of the pattern is completed and the price crosses the neckline level too.

To estimate how much price will move after the neckline is broken, traders usually measure the distance from the neckline to the top of the head vertically. Then they predict the same movement on the opposite side from the neckline and vice versa for reversal head and shoulder pattern.

Trading decision based on head and shoulder pattern:

As the pattern indicates major trend reversal from bullish to bearish, whenever the pattern forms at the end of the uptrend, there is a high possibility of the reversal of the uptrend. So, if you bought shares of a company and find head and shoulder pattern forming, it won’t be a wise idea to hold your position because if the trend starts to reverse, you may lose most of your profit. So, after the formation of the head and shoulder patterns, it will be better to exit your positions. Another key thing to note, these chart patterns are highly dependent on timeframes. The bearish movement after the pattern forming on the 15-minute chart will always be less than the 1-day chart.

Whenever you find the reversal head and shoulder pattern at the end of a downtrend, you can buy shares of that company based on your trading strategy. Reversal head and shoulders always give a clear indication of a trend reversal from bearish to bullish. When a stock is in a downtrend, you should be alert to find the best opportunity to buy this share. At the end of the downtrend, when the reverse head and shoulder forms it means there is a major change in the sentiments among the traders. More people are willing to buy this share that causing the price to get rejected from going down as a result the reverse head and shoulder pattern forms.

Conclusion:

There are many chart patterns and different strategies for reversal trading. Head and shoulder is one of the best historically proven chart patterns that give a clear indication of the trend reversal. People like reversal trading because of the huge movement after trend reversal which can generate huge money. For traders, the head and shoulder pattern is an easily recognizable and reliable chart pattern that gives an authentic signal of a trend reversal. When the head and shoulder pattern is identified correctly, it can provide a big profit opportunity.