Head and Shoulders Pattern Key Concepts
What is the Head and Shoulders Pattern?
The head and shoulders pattern is a type of chart pattern that is used in technical analysis to predict reversals in the market. This chart formation consists of three consecutive peaks, with the middle peak (head) being the highest and the two outside peaks (shoulders) being lower than the head.
In a proper head and shoulders pattern, the second shoulder is tighter than the first shoulder and generally doesn't reach the same high as the first shoulder. The pattern is considered to be complete when the price falls below a line connecting the two low points of the two shoulders. This breakout is then taken as an indication that the trend has reversed and sellers are in control.
Is the Head and Shoulders Pattern Bullish or Bearish?
The head and shoulders pattern can be both bullish or bearish, depending on the direction of the trend leading up to the formation. If there is an uptrend leading up to the head and shoulders pattern, then it is considered a bearish reversal pattern, indicating that prices will likely fall.
If there is a downtrend leading up to the formation, then it is considered a bullish reversal pattern and prices are expected to rise. This is called the inverse head and shoulders pattern. In either case, the head and shoulders pattern indicates a reversal of the current trend.
Head and Shoulders Pattern Characteristics
- A sharp surge to new highs, followed by a sudden drop below the 10-week moving average.
- Multiple attempts to recover above or near the 10-week line, encountering resistance each time.
- In most cases, a left shoulder, head, and right shoulder formation is seen over 5-7 months.
- The right shoulder typically forms at lower prices than the left shoulder.
Head and Shoulders Pattern Example
Head and Shoulders Pattern Trading Mistakes
The key to successful trading with this chart formation is timing. Traders should look to enter at the break of the neckline. Additionally, traders should consider exiting their trade when the price moves back above the 10-week moving average or the highest point of either shoulder.
Trying to trade against the trend and guessing when a high has been reached can be an expensive mistake. Instead, traders should wait for confirmation of a reversal by looking for price action to break the neckline before entering any trades based on the head and shoulders pattern.
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Head and Shoulders Pattern Psychology
The head and shoulders pattern is often seen as a sign of market exhaustion. It typically signals that traders have become overly bullish after a sustained uptrend, followed by the realization that prices are too high to sustain the current trend. When the right shoulder fails to make a new high it tells you that sellers are in control and that the market sentiment is shifting.
When to Sell Stocks Short
While long traders will use the head and shoulders pattern to identify when to exit their long positions, bearish investors, or short sellers, might look to the pattern as a sign that they should enter into a short position. Short sellers will look for the pattern to form and then wait for price action to break below the neckline before entering into a short position. This trade should be managed carefully, as price can quickly recover and violently swing during these periods of increased volatility.
Inverse Head and Shoulders Pattern
The inverse head and shoulders formation is the opposite of the traditional head and shoulders pattern. The inverse head and shoulders pattern occurs after a downtrend and signals a potential reversal to the upside. The pattern consists of three consecutive troughs, with the middle trough being the lowest and the two outside troughs being higher than the middle trough. The pattern is considered to be complete when the price moves above a line connecting the two high points, or neckline, of the two shoulders.
The Bottom Line
The head and shoulders pattern is a powerful chart formation that can be used to identify potential reversals in the markets. It is important for traders to remember that the pattern is only a potential sign of a reversal and should not be used as the sole indicator when trading. Additionally, traders should wait for confirmation of a reversal before entering or exiting any trades based on the pattern.
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