What is a Head and Shoulders Chart Pattern?
The "head-and-shoulders" pattern, when applied to a technical chart analysis, is believed to be one of the most reliable trend-reversal patterns – where the market trend is experiencing a reversal process either due to a bullish or bearish trend – and where a characteristic pattern takes shape; and is recognized as a reversal formation. This pattern is extremely popular among traders and investors as it is considered to be one of the most reliable of all the formations, and it also appears to be an easy one to spot.
Types of Patterns
There are two main versions of the head-and-shoulders pattern, which are:-
1. The head-and-shoulders top provides a signal that a security's price is set to fall. The pattern is usually complete when a peak of an upward trend is reached.
2. The head-and-shoulders bottom -- also known as inverse head and shoulders – provides a signal that a security's price is set to rise. This is indicated when a downward peak is reached during a downward trend.
There are many variations, some of which can be just as valid as the classic formation. Other factors - including volume and the quality of the breakout - should be considered in conjunction with the pattern itself.
Make-up of a Head and Shoulders Chart Pattern
These two versions of a head and shoulder chart pattern and are based on similar formations consisting of four parts, as can be observed in the diagrams above:-
1. Left shoulder,
2. Head,
3. Right shoulder, and
4. Neckline
Peaks and troughs are apparent due to the display of the head and shoulders.
The neckline provides a level of support or resistance depending on the direction taken – and once the neckline is broken after the formation of the second shoulder the signal/pattern is confirmed.
Development of the Head and Shoulders Pattern
Charles Dow, who developed the “Dow Theory of peak-and-trough analysis, and later refined by S.A. Nelson and William Hamilton, is the basis of the head and shoulder pattern. When there is a period of rising peaks and troughs it is considered that an upward trend is being experienced. The opposite occurs with a downward trend where the peaks and troughs are falling. A weakening of a trend can be seen when the head and shoulders pattern displays deterioration in the peaks and troughs.
Head and Shoulder Chart Pattern Requirements
1. Price
Again, this is recognizable in three (3) stages:-
1. The left shoulder -- where the price of the financial instrument in a rising market hits a high and then falls back.
2. The head – where the prices rise to an even higher high and then fall back again.
3. The right shoulder -- when prices rise to a peak again but don't go as high as the head, then falls back again after hitting a high similar to the left shoulder.
If the shoulders are lower than the head and roughly equal to one another, then a classic formation has occurred.
2. Volume
This is a necessary requirement for a true head and shoulders chart pattern to be recognized -- the volume level must show a peak on the left shoulder, a lower peak at the head, and then an even lower level at the right shoulder. This head and shoulders formation can be verified by drawing a downtrend line on the volume chart – and it needs to match with the price pattern.
3. Neckline
The neckline is an important element for this head and shoulders chart pattern. The neckline begins at the first low point at the end of the left shoulder and at the beginning of the uptrend to the head – and a line is now drawn to where the point ends on the downtrend from the head and the beginning of the upturn to the right shoulder. The line may not always be horizontal but may slope up or down.
When the price of the stock or other instruments that are being followed, drops below the neckline -- after falling from the high point of the right shoulder – the neckline is classed as “broken” – therefore completing the pattern.
Note: Many technical analysts believe that the pattern is not completed because the trade is below the neckline but should also close below it.
Chart patterns are prevalent and occur in all timeframes – one-minute charts, daily charts and weekly charts – and by providing easy-to-see important information, such as entry and stop levels, as well as price targets, the formation becomes easy to implement.
The head and shoulders chart pattern is not only a predominant pattern used by short sellers profiting from downtrends, but also for day and swing traders because the pattern continually appears on all times frames.
Conclusion
Since the head and shoulders pattern is classed as a major reversal formation, an excellent opportunity for shorting becomes available. It can also provide an early warning signal for the selling of long positions which may be in an unenviable position of a major downtrend.
It is also important for the trader/investor to consider their trading time horizons and adjust the duration of the pattern accordingly. Obviously for a short-term trader a short duration of a pattern is desirable, whereas, a long-term trader may be more comfortable with a long duration pattern.