Types Of Chart Pattern Head And Shoulders

Head And Shoulder

Types Of Chart Pattern Head And Shoulders – Technical analysis is based on the premise that history repeats itself. It follows, then, that if you can analyze the recurrence of identifiable patterns and formations that have preceded or accompanied important market movements in the past, you can get important clues about the future.

Some chart patterns are more reliable than others for price forecasting — but none is infallible. Some patterns are very reliable, while others do not end in the price target one would expect. Our effort here is to focus on a select group of chart patterns that have been proven to be of considerable validity over many years.

Head And Shoulders

Broadly, there are two types of price patterns that develop on charts:

Reversal patterns, and

Continuation patterns.

Reversal Patterns: What They Are

Reversal patterns signal that a trend is about to reverse direction for a period of time. Thus, reversal means a change in direction, and a pattern is a chart formation. Thus, reversal patterns are chart formations that indicate a reversal in the direction of the ongoing trend. These patterns can be spotted on the daily, weekly or monthly charts. Technical patterns apply to all of these time
frames.

Head And Shoulders

Reversals can be in either direction, i.e. from up to down, or from down to up. In either case, characteristic patterns take shape on price charts presenting an alert trader the opportunity to establish a trade that should have a higher probability of success.

Head and Shoulders Pattern

A head and shoulders reversal pattern forms at the end of an up trend, and its completion marks a trend reversal. Thus, head and shoulders patterns are top reversal patterns.

The pattern comprises of three peaks with the middle peak (head) being the highest, and the two flanking peaks (shoulders) being lower and roughly equal. The reaction lows of each peak can be connected to form a support line, called the neckline.

As its name implies, this pattern resembles the upper portion of a human torso and is made up of a left shoulder, a head, a right shoulder and a neckline. Other parts playing a role in the pattern are volume, the breakout, price target and support turned resistance.

Head And Shoulders

Left Shoulder

The left shoulder is formed after an extensive increase in price, usually supported by high volume. This is the first peak of the ongoing up trend.

After making this peak, the price dips slightly, usually on lower volume, to complete the formation of the shoulder (Point 1 in Figure 1). This dip is the start of the neckline and the head is about to form.

Head

The head is formed with heavy volume on the rising side of the head, and lower volume on the falling side. Prices then fall to somewhere near the same level as the low of the left shoulder (Point 2 in Figure 1).

Head And Shoulders Pattern

Right Shoulder

The right shoulder is formed by a rally in the price to a level roughly equal to that of the left shoulder. Again it can be slightly higher or lower but it must definitely be below the high achieved by the head.

The decline from the peak of the right shoulder should then break the neckline.

Head And Shoulders

Neckline

You can draw the neckline by connecting low points 1 and 2 in Figure 1. Depending on the relationship between the two low points, the neckline can slope up, slope down, or even be horizontal.

The slope of the neckline will affect the pattern’s degree of bearishness; a downward slope is more bearish than an upward slope.

Sometimes more than one low point can be used to form the neckline. Once the right shoulder has started to form you can draw in a neckline across the bottoms created between the left shoulder and the head, and the head and right shoulder. When the price falls from the right shoulder and breaks through the neckline, the head and shoulders top formation is confirmed and it is your signal to go short or sell the stock.

The head and shoulders pattern is not complete, and an up trend is not reversed, until the neckline support is broken.

Volume

One of the important habits you must develop is to learn to look at volumes accompanying the various chart patterns. You must always pay attention to this critical and important factor to avoid being fooled by the market and the price chart.

Volume always plays an important role in the formation of a head and shoulders pattern, which must have the following volume characteristics:

  • Formation of the left shoulder should be accompanied by an increase in volume, which should then come down upon its completion.
  • Volume should then increase again with the development of the head. This second surge of volume is usually less than that during the development of the left shoulder indicating that buyers aren’t as aggressive as they once were.
  • Volume then decreases and this reduced volume should persist throughout the development of the right shoulder, and then expand as new selling comes in and earlier buyers get out. The smart money has then completed distribution to the unsuspecting retail traders.
  • Breaking of the neckline with increasing volume completes the pattern.

Please also remember that the head and shoulders top formation does not need to always be perfectly symmetrical. The time taken to create each of the shoulders may be different. This will cause one shoulder to look slightly larger than the other even though it has reached a similar high point.

Head And Shoulders

Head And Shoulder

Weekly charts are useful in detecting bottom reversals but the weekly chart in Figure 3 shows a top reversal. Look at the rise in volume with the formation of the left shoulder. The breakdown of neckline with increased volume completed the pattern. LIC Housing Finance again made an attempt to surge higher, but could not break the neckline as the volumes were low.

Broken Neckline Acting as Resistance

Once the neckline is broken, it is common for this level to turn into a resistance. Sometimes, but not always, the price will pull back to the test the neckline level and this offers a second chance to sell.

Why a Head and Shoulder Pattern Forms

Distribution of the stock by people who believe that the price has reached a peak results in a head and shoulders formation.

Sellers come in at the highs (left shoulder) and the downside is probed (thus initiating the neckline). Buyers soon return to the market and ultimately push through to new highs (head). However, the new high is quickly turned back and the downside is tested again (continuing neckline). Tentative buying re-emerges and the price rallies once more but fails to take out the previous
high (right shoulder). Buying then dries up and the market tests the downside yet again. This represents the selling of unrealized hopes when prices fail to reach their previous high

Towards the end of an up trend, only retail traders and speculators remain bullish on a stock, while institutional investors turn bearish.

If a head and shoulders pattern does not break down in a reasonable period of time, it loses its strength in the breakdown direction. It then spends itself out making an indecisive sideways pattern.

Inverted Head and Shoulders Pattern

The head and shoulders pattern can sometimes be inverted. The inverted head and shoulders pattern typically reverses a down trend (see Figure 4). Volume plays a major role in confirming the formation.

Patterns such as the inverted head and shoulders are also known as bottom reversal patterns and usually take a longer time to build as compared to top reversal formations.

Inverted Head And Shoulder

The following characteristics of an inverted head and shoulder patterns should always be kept in mind:

  • The inverted left shoulder should be accompanied by an increase in volume.
  • The inverted head should then be made on lighter volume.
  • The rally from the head, however, should show greater volume than the rally from the left shoulder.
  • The inverted right shoulder should see the lightest volume of all. When the market then rallies through the neckline, big volumes must accompany it.

Failed Head and Shoulders Pattern

In the 2007 Cricket World Cup, India and Pakistan were tipped to qualify for the super eight stage. With a strong batting line up, everybody expected India to qualify even for the semi finals. But Bangladesh beat India, and Pakistan was beaten by Ireland and neither team could even make it to the super eight. This result was not predicted by any of the cricket pundits. In technical
analyst’s jargon, it was a failed pattern. Later on, Bangladesh beat even South Africa, a strong contender for the cup.

In charting, similarly, sometimes even the most recognized and time-tested patterns fail. While some chart patterns are more reliable than others for price forecasting, but none is infallible. They may have a high probability of success but are not guaranteed to work all the time. Thus, while head and shoulders patterns follow through a majority of the time, there are occasions when the pattern fails. In such cases, the price never drops below the neckline after forming the right shoulder. A failed head and shoulders pattern typically occurs when the patterns in two time frames are contradictory. In such a situation, the pattern in the higher time frame always prevails. Then, too, pattern breakouts on low volume are always suspect, so do look for high volume breakouts in all patterns.

Thus, a failed head and shoulders pattern occurs when the price rallies above the high of the head after forming the right shoulder. When the price rallies above the head, make sure to quickly cut your losses if you are short because the move is usually strong if there are enough buyers to push through all that resistance and set a new high. After getting through the resistance of
the head and shoulders pattern, the failed short setup often becomes a great long play (see Figure 5).

Failed Head And Shoulder

Look at the formation of the left shoulder in Figure 5. NP did break below the neckline in late July but did so with negligible volume. Thus, the volume did not follow the formation of the pattern. In fact, NP made an up move in the first week of August by breaking above the neckline with volume.

Later, the stock made double top formations, respectively in September and December 2005, by touching a high of 300 before plunging to low of 153 in June 2006.

While technical analysis literature emphasizes beautiful, successful patterns, there is much less discussion about failed patterns. When they fail though, they can lead to sharp moves in the opposite direction as traders who are trapped in the direction of the expected breakout then rush to exit the market. It is advisable for traders not to preempt the final breakout, and in case you do so, remember to keep a stop loss above / below the right shoulder as the case may be.

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