Head and Shoulders Chart Pattern Explained for Dummies

What is a chart pattern?

A chart pattern, commonly referred to as a price pattern, is a distinctive graphical illustration of price movements of, amongst others, securities (such as stock), currencies, commodities, and cryptocurrencies. The brokerage company IG describes a chart pattern as ‘a shape within a price chart that helps to suggest what prices might do next, based on what they have done in the past.’ Chart patterns are the foundation of technical analysis (TA), which can be described as the study of trends in the historical movements of prices[1] of, inter alia, securities, and currencies. The primary goal of TA is to identify price patterns in order to predict future price movements. A pattern is created by drawing a line that connects common price points, such as highs or lows, during a given period of time. Chart patterns can be based on time periods such as seconds, minutes, days, and even months. Traders using technical analysis have various chart patterns at their disposal, including:

1. The head and shoulders pattern

The article will focus on this chart pattern.

2. The inverse head and shoulders

The article will also explain this type of chart pattern.

3. The double top pattern enables traders to identify trend reversals.
4. The double bottom pattern is a bullish reversal pattern, showing the discontinuation of a downtrend and a movement towards an uptrend.
5. The rounding bottom pattern can signal a reversal or a continuation. For example, during an increase in a security’s price (an uptrend), the price may drop slightly before it starts rising again - an indication of a bullish continuation.
6. The cup and handle pattern is a continuation chart pattern, signalling the continuation of a bullish market trend.
7. The wedge pattern comprises two types of wedges:

• The downward wedge, also called the falling wedge, usually indicates that the price will increase and break through the resistance level.
• The rising wedge, also known as the ascending wedge, is a bearish chart pattern, signalling that price is about to break through the level of support.

8. Pennants, also called flags, are patterns that can either represent a continuation or a reversal in a bullish or bearish
9. The ascending triangle pattern signals that an ongoing bullish trend will continue.
10. The descending triangle pattern indicates a downtrend in a bearish market.
11. The symmetrical triangle pattern, usually a continuation pattern, can be either bearish or bullish, depending on the overall trend in a financial market.

  (The term ‘bullish’ refers to the belief that the price of an asset will rise. Contrarily, the term ‘bearish’ refers to the belief that the price will fall.) There is no ‘champion’ or ‘the best’ chart pattern because they are all used in technical analysis to identify different trends in price and in numerous financial markets. Some chart patterns are more suitable for volatile markets, while others do not meet the requirements. Furthermore, some patterns are more suited to a bullish market, while others are very useful when trading in a bearish market. There are three types of chart patterns, namely:

• Continuation chart patterns, indicating that an ongoing trend (bearish or bullish) will continue.

• Reversal chart patterns, signalling that a trend is expected to change direction. For instance, a downward trend can change to an uptrend or vice versa.

• Bilateral chart patterns allow traders to be aware that the price could move up or down, indicating a highly volatile market.

 

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What is the head and shoulders chart pattern?

The head and shoulders chart pattern, also called the topping pattern, is a reversal pattern that is most often recognised in uptrends, signalling the end of an uptrend. It allows traders to identify a reversal from bullish to bearish. It is a technical indicator, considered one of the most reliable reversal chart patterns, and significantly helpful in trading securities, currencies, commodities, and cryptocurrencies, to name a few. It is a chart pattern comprising four key features, namely:

• The left shoulder is a peak on the left of the head. It is smaller than the peak representing the head.

The left shoulder is formed when traders who have pushed a price higher, temporarily lose enthusiasm.

• The head is the highest peak of the pattern, developing when traders’ enthusiasm peaks and then drops to a level at or near the previous low of security, such as stock, or currency.
• The right shoulder is a peak that is formed to the right of the head and also lower than the head.

The right shoulder is created when the price improves once again but is unsuccessful in reaching its previous high before dropping again. Ideally, the shoulders should be at the same (as indicated in the illustrations) or near the same price level. However, symmetrical shoulders are particularly difficult to identify. Hence, asymmetrical peaks that represent the left and right shoulders of the pattern, are also broadly accepted, provided that the difference in height between the two peaks is not extensive.

• The neckline is a trend line that joins the bottoms of the two shoulders.

The most important feature of the head and shoulders pattern because when a price falls below this trend line, it is a strong signal that the pattern has broken, breaking out into a bearish downtrend. In reality, the neckline is seldom a straight horizontal line as indicated in the illustration. Actually, the slope of the neckline can either be up or down. When the slope is down, it typically gives a more reliable signal. [i] When the words prices, price, a price, or the price is mentioned, they can be applicable to securities, commodities, cryptocurrencies, currencies, or any assets that can be traded.  

What is the inverse head and shoulders chart pattern?

The inverse head and shoulders pattern commonly called the reverse head and shoulders pattern or the bottoming pattern is the exact opposite of the head and shoulders pattern. Express, in other words, is an upside-down head and shoulders pattern. It occurs in a downtrend and is described as a bullish reversal pattern, signalling that a bearish trend has changed into a bullish trend. The inverse pattern comprises the same features like the head and shoulders pattern. However, the features are signalling the exact opposite info about price performances. The features are:

• The left shoulder is a valley (trough) formed on the left of an even lower valley, referred to as the head.

The left shoulder is formed after the price has dropped and then temporarily surged.

• The head, which is the middle and lowest valley (trough) of the pattern, develops when the price drops down through the old lows, creating a subsequent new low.
• The right shoulder is a valley (trough) at a higher level than the head and is formed after the price has rebounded from the lowest valley (the head) to peak at the neckline before dropping again to a higher low than the head.
• The neckline is a trend line, drawn between the swing highs of the left and right shoulder, respectively.

When the price crosses the neckline after the second shoulder in an upward direction, it is an indication that the bearish trend has reversed and that the price is likely to keep increasing, representing a bullish trend.  

Trading[2] with the head and shoulders chart patterns

This is not a detailed description of how to trade with the head and shoulders patterns. Only a few basic principles are provided. Firstly, be aware that even when a price breaks the neckline, it does not unquestionably prove that the reversed trend will continue. To support the confirmation of the trend, the following two factors should be considered:

• Volume: For instance, the quantity of a company’s shares trading is one indication of the strength behind a price move in an upward direction. A drop in trading volume could signal limited investor and trader enthusiasm.

Alternately, an increase in volume when the price falls below the neckline is a sign that selling pressure will remain intense.

• Time period: To be profitable, trend reversals require strong trends preceding One common rule of thumb is that the uptrend leading into the bullish trend should be at least double the distance between the two shoulders.

Before starting to trade, it is important that a head and shoulders pattern completes itself. Furthermore, ensure that the neckline is broken, and the reversed trend is confirmed. Plan your trade ahead of time, including the entry, stops, and profit targets. The most common entry point occurs when the price breaks the neckline. Regarding stops:

• topping pattern - a stop is typically placed above the right shoulder.
• bottoming pattern - a stop is placed below the right shoulder.

Regarding a profit target:

• The regular head and shoulders pattern - the profit target is the price difference between the height of the head (the highest peak) and the neckline.

The inverse pattern - a profit target is set by calculating the difference between the lowest trough/valley (the head of the pattern) and the neckline   [1] When the words prices, price, price, or the price are mentioned, they can be applicable to securities, commodities, cryptocurrencies, currencies, or any assets that can be traded. [2] The article does not provide investment or trading advice. The material is for general information purposes only.

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