Analyzing Chart Patterns: Head And Shoulders

Analyzing Chart Patterns: Head And Shoulders

Head and Shoulders Top

The head-and-shoulders pattern is one of the most popular and reliable chart patterns in technical analysis. And as one might imagine from the name, the pattern looks like a head with two shoulders.

Head and shoulders is a reversal pattern that, when formed, signals the security is likely to move against the previous trend. There are two versions of the head-and-shoulders pattern. The head-and-shoulders top is a signal that a security's price is set to fall, once the pattern is complete, and is usually formed at the peak of an upward trend. The second version, the head-and-shoulders bottom (also known as inverse head and shoulders), signals that a security's price is set to rise and usually forms during a downward trend.

Both of these head and shoulders have a similar construction in that there are four main parts to the head-and-shoulder chart pattern: two shoulders, a head and a neckline. The patterns are confirmed when the neckline is broken, after the formation of the second shoulder.

The head and shoulders are sets of peaks and troughs. The neckline is a level of support or resistance. The head and shoulders pattern is based on Dow Theory's peak-and-trough analysis. An upward trend, for example, is seen as a period of successive rising peaks and rising troughs. A downward trend, on the other hand, is a period of falling peaks and troughs. The head-and-shoulders pattern illustrates a weakening in a trend where there is deterioration in the peaks and troughs.

Head and Shoulders Top
Again, the head-and-shoulders top signals to chart users that a security's price is likely to make a downward move, especially after it breaks below the neckline of the pattern. Due to this pattern forming mostly at the peaks of upward trends, it is considered to be a trend-reversal pattern, as the security heads down after the pattern's completion

This pattern has four main steps for it to complete itself and signal the reversal. The first step is the formation of the left shoulder, which is formed when the security reaches a new high and retraces to a new low. The second step is the formation of the head, which occurs when the security reaches a higher high, then retraces back near the low formed in the left shoulder. The third step is the formation of the right shoulder, which is formed with a high that is lower than the high formed in the head but is again followed by a retracement back to the low of the left shoulder. The pattern is complete once the price falls below the neckline, which is a support line formed at the level of the lows reached at each of the three retracements mentioned above.

Again, there are four steps to this pattern, starting with the formation of the left shoulder, which occurs when the price falls to a new low and rallies to a high. The formation of the head, which is the second step, occurs when the price moves to a low that is below the previous low, followed by a return to the previous high. This move back to the previous high creates the neckline for this chart pattern. The third step is the formation of the right shoulder, which sees a sell-off, but to a low that is higher than the previous one, followed by a return to the neckline. The pattern is complete when the price breaks above the neckline.

The Breaking of the Neckline and the Potential Return Move
As seen from the above, the head-and-shoulders pattern is complete when the neckline is broken; the trend is then considered reversed, and the security should be heading in a new direction. The point of breakout is when most traders following the pattern would enter the security.

However, the security will not always just continue in the direction suggested by the pattern after the breakout. For this reason it's important to be aware of what is known as a "throwback" move. This situation occurs when the price breaks through the neckline, setting a new high or low (depending on the pattern), followed by a retreat back to the neckline.