Head And Shoulders Pattern

Marking the patterns and realising their significance is essential for executing successful trades. The traders and analysts continuously monitor trends and patterns while keeping a close eye on the market to spot upcoming price movements. 

What is a Head and Shoulder Pattern?

Head and shoulders pattern meaning: The head and shoulders pattern is a major pattern amongst numerous traders. It is reliable, highlighting the price action for various securities or indices alongside Forex trading. 

The head and shoulders pattern is a price reversal chart that helps identify reversals. It forms a baseline of three peaks. The outer two are the same height, with the middle being the highest. The head and shoulders pattern predicts the bullish-to-bearish trend reversal during technical analysis.

A Head and Shoulder pattern occurs when the stock price rises to a peak and slides down back to the base. After this, the price increases above the previous peak level, forming the nose. Then it once again declines back to the original base. The stock price rises again to the initial peak level and returns to the base again. 

The head and shoulders pattern consists of the following three components –

1. After a prolonged bullish trend, the price increases to the thick and then falls back to form a trough.
2. Prices again rise forming 2nd high considerably higher than the initial peak and further drops.
3. The price increases for a third time. However, this increase is only equal to the first peak before it goes down again.

Here the first and the third peaks are shoulders. The second peak is the head. The line joining the first and second trough forms the neckline.

Market Conditions Functioning Behind Head and Shoulders Pattern

Each of the charting patterns reveals a particular picture regarding the tussle between the bulls and the bears. The ups and downs of the head and shoulders pattern are no exception. The first peak and subsequent decline stand for the losing momentum before the bullish trend. The bulls always try to keep the upward movement prevailing for as long as possible. 

Their urge to sustain this trend makes prices move back to their initial peak. It results in achieving the new high forming the head. It is quite probable that the bulls can enforce their market dominance once again. So, the upward trend continues. 

Despite this, the price of the asset declines for the second time, going to a point below the initial peak. It is an indication of the bears getting stronger again. The bulls try, once again, to raise the price of the asset. However, they only manage to take it to a level less than the initial peak. Their failed attempt to price above the highest level signals their defeat and win for the bears. This drags the price down and hence completes the reversal. 

Interpreting the Head and Shoulders Pattern

This pattern is highly unique. It is useful in determining the price. It facilitates the traders to execute their stop orders too. In a peaking pattern, the placement of tops is usually above the top of the head price. To estimate the range of price movement after breaking the neckline, one needs to note the distance vertically from the top of the head to the neckline. Then we need to subtract that distance from the neckline in its opposite direction, from where prices first crossed the neckline after the second shoulder formed. When working on the pattern, measure the vertical distance from the top of the head to the neckline. 

How to Use the Head and Shoulder Pattern

You now know the head and shoulders pattern, so let’s discuss how to use it. The head and shoulder pattern should be complete before you must execute any trade. If it is in the formation phase, one should not resume.  The market can fluctuate even with small events. Hence it is advisable to observe the trends till they completely develop. Plan the trade well before remaining ready as soon as the neckline breaks. Keep an eye on the variables which may necessitate changing the entries profit head and shoulders pattern target or stops. 

Some traders pick alternate entry points which need patience and swift action at the appropriate time. They properly watch the neckline breaks and wait for the prices to again go up to the neckline or slightly above it. However, a trader can wait for the chance to enter a trade at even more favourable price points. The downside of this strategy is that the particular price point may never arrive, and you could lose out on the trading opportunity. 

What Does a Head and Shoulder Pattern Suggest?

The head and shoulders depict a bullish to a bearish market trend reversal. It provides clear signals that the upward trend is very soon coming to its end. Investors and traders generally see it as a very trustworthy trend reversal pattern. The trader prefers the neckline as the entry point of their trade. They are considering the stop above or below the right shoulder. The profit margin will be the difference between the high and low with the pattern added or subtracted from the breakout price of the stocks. Although the method is not perfect, it still provides logical price movements and a better probability of profits.

Example of a Head and Shoulder Pattern

The following example will make a detailed case for the functioning of a head and shoulders pattern. Let’s suppose a stock goes down, cutting the neckline after the formation of the left and right shoulders and the head. It indicates that it may further go down. Here the right shoulder is very small. Since the price does not lean back to the head, it shows excessive selling. It is the head and shoulders top chart pattern. 

Plan your trades in advance, so you are ready to make your investment entry when the neckline breaks.  One more alternate entry point that a trader often chooses. It is basically an alternate approach when the neckline is broken and waits for the price to move upwards or just above the neckline of the head and shoulder pattern. This is the most common step followed by a technical trader and thus allows a trader to trade at a favourable price. But beware of the possibility of an uptrend that might not happen.

Inverse Head and Shoulder Pattern

The inverse head and shoulders pattern forms during downtrends. The price first goes down and increases for the left shoulder. Then the price falls to a new low and shows upwards. 

The price doesn’t go to a new low and increases again. It gives rise to the right shoulder. After the left shoulder and head, the high swings connect a trendline forming the neckline. As the price cuts through the neckline reaching above it, there are high chances the price will further increase. 

Conclusion

It is always preferable to stay with your trading plans, keeping in view your appetite. Go for the trades that can help you reach your goals. The head and shoulders pattern is an excessively dependable tool for traders. It has provided accurate results for the trend reversal for a long time now. 

Although no charting pattern works all the time, the head and shoulders pattern properly signals any significant trend changes. At the same time, it represents a good opportunity to generate profits. I hope this article is helpful for you to understand what is a head and shoulders pattern.