What is a Head and Shoulders Pattern?
This is a specific formation which helps to predict a bullish to bearish trend reversal. It has three peaks where middle is highest and symbolizes the head while other peaks signify both right and left shoulders.
This design has been found to be reliable when it comes to understanding behaviors of a market. One thing you need to note is that it cannot be identified until a third peak has been formed and confirmed.
Unfortunately, when this happens, the market will have already declined. Despite this, it is useful when it comes to setting targets for an upcoming market fall.
How to identify Head and Shoulders pattern
During formation, the left shoulder forms at a long uptrend end. It is common for prices to decline further thus signaling end of a previous uptrend. As a result, a peak is usually left.
Prices do rally finally forming a much higher peak.
From here, prices decline and create a new short term downtrend thus forming a head. What you ought to know is that it takes several weeks between formation of a left shoulder and head.
As a reversal pattern that occurs during an uptrend, it helps to signal that it (uptrend) is over. As prices progress higher, they will form a high point and a retrace.
This will become a new higher high and another retrace. When price is pushed much higher, it will be unable to attain its last high level. As a result, three peaks will be formed finally creating a head and shoulders pattern.
It is important to note that two retracements will occur – one after left shoulder and another after its head.
There low points can be connected with a trend line which is also referred to as a neckline.
Trading with head and shoulders pattern
As an easy to spot pattern, it is known to appear on all time frames. This means that it can be utilized by day traders, investors and swing traders alike.
What you ought to know is that entry, stop levels and price targets help with formation and implementation of the trading tool finally providing easy to see levels.
To trade with it well, it’s wise not to assume that it will develop or that it will be partially formed very soon. While it’s wise to keep an eye on partially or concluded patterns, no trading should be made until they break a neckline.
Savvy traders are known to wait for price actions to move lower than a neckline especially after a right shoulder peak. In an inverse head and shoulder pattern, price actions should move above a neckline once the right shoulder is formed.
To trade with this pattern, wait until it completes. It is wise to plan trades beforehand. Start by writing down entry, stop and profit targets. Make sure you note all variables that may affect your profit target.
To enter a trade successful, determine where a breakout occurs. This refers to moments when a neckline is broken.
Head and Shoulders – Why it works
a. It works when a security’s price falls from a market high and sellers begin to enter a market. Furthermore, there is less aggressive buying
b. When a neckline is approaching, there are traders and investors who will seek exit positions thus driving prices towards a profit target
c. It is important to know that a right shoulder may not be broken until an uptrend is attained
Bottom Line
As an investor, it is wise to keep in mind that this pattern happens during an uptrend which marks its potential end.
The head and shoulders pattern is composed of three peaks – left shoulder, head and right shoulder.
Two retracements are located between and when it is complete, it helps to provide a short entry point.