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What is Head and Shoulder Pattern?
The Head and Shoulders pattern is a chart formation used in technical analysis to indicate a security's reversal in price direction. The technical indicator is based on historical prices, and investors and analysts often use the pattern to determine primarily whether a downtrend is imminent. It is most commonly used with stocks, but is also popular in forex, commodities, and cryptocurrencies. The typical Head and Shoulders pattern is characterized by an initial rally to a peak (the first shoulder) followed by a brief decline, which is then followed by another rally to a higher peak (the head), after which the stock falls again briefly before rallying to a third peak at nearly the same level as the first (the second shoulder). This third peak (and second shoulder) theoretically indicate the beginning of a bearish decline, or a longer period of declining asset prices.Important Information:
Head and Shoulders Pattern: Characteristics, How to Read, and Examples of Patterns
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Characteristics of the Head and Shoulder Pattern
In technical analysis, the head and shoulders pattern is a predictive chart formation that usually indicates a trend reversal where the market shifts from bullish to bearish, or vice versa. The pattern has long been touted as a reliable pattern that predicts trend reversals. Before we go any further, it is important to remember that the Head and Shoulders pattern is almost never perfect, meaning that there will likely be small price fluctuations between the shoulders and the head, and the pattern formation is rarely perfect in its appearance. There are three main components to the Head and Shoulders pattern.
Before we explain each part, take a look at the image below. hns pattern This image is a clear representation of the three parts of the pattern – the two shoulder areas and the head area that price passes through in creating the pattern that signals a market reversal. The first “shoulder” forms after a significant bullish period in the market when price rises and then falls to a trough. The “head” then forms when price rises again, creating a high peak above the level of the first shoulder formation. From this point, price falls and creates the second shoulder, which usually looks similar to the first shoulder. Importantly, the initial decline does not bring it significantly below the first shoulder level before there is usually a slight upward retracement or flattening of price movement. Important Info:
Difference between HnS Pattern and Inverse HnS Pattern
The inverted Head and Shoulders pattern is a reversal pattern. (A reversal chart pattern is a pattern that signals a change in the current trend. Reversal patterns can be either bullish or bearish; a bullish reversal pattern signals the start of an uptrend, while a bearish reversal pattern signals the start of a downtrend.) It consists of three troughs, with the two outer troughs being of equal height and the middle trough being the deepest, like a human Head and Shoulders hanging upside down. The market resistance level forms the neckline. The inverted Head and Shoulders pattern signals a reversal from a bearish trend to a bullish trend. The Head and Shoulders chart pattern is a price reversal pattern that helps traders identify when a reversal may be underway after a trend has exhausted itself. This reversal signals the end of an uptrend. The Head and Shoulders pattern has a distinctive appearance that resembles its namesake which includes distinct ‘left shoulder’, ‘head’, ‘right shoulder’ and ‘neckline’ formations.Important Information:
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How to Trade with Head and Shoulder
Trading the Head and Shoulders pattern can involve substantial volatility. Looking to short on the initial break of the neckline can be fraught with danger, given the importance and consequences of breaking that support level. This can increase the likelihood of a ‘fake-out’, where price breaks the neckline and then reverses higher once again. With that in mind, it makes sense to look for some form of confirmation that the breakout will hold. One such method is to wait for a candle to close below the neckline. The higher the time frame of the candle, the greater the amount of confirmation a close below support will provide. Alternately, some traders will hold their entry longer, with a reversal back to the neckline after the initial breakdown providing that sell signal. This allows for greater confirmation that price action can hold below the neckline. However, it also increases the likelihood that a trader will miss an entry, with a rapid breakdown often meaning no retest occurs.Important Information:
Types of Bullish Trend Patterns and Examples and Conditions
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Advantages and Disadvantages of the Head and Shoulder Pattern
Although the Head and Shoulder pattern offers no guarantees as it is largely a matter of personal interpretation, it is one of the most popular chart formations for a number of reasons with its own pros and cons.Advantages of the Head and Shoulder pattern
- High probability pattern to predict trend reversal;
- Assists in estimating profit and price targets and risk levels;
- Relatively easy to identify for use by both novice and experienced traders;
- Benefits from market shifts;
- This can be applied to multiple markets.
Head and Shoulder pattern cons
- Chart formations, including Head and Shoulders, can be subjective;
- The probability of occurrence is different for different time frames;
- Interpretation – the neckline can also be a trend line;
- Confirming a changing trend can be difficult for novice traders because price can still shift at the neckline;
- The risks and rewards may not be favorable.
Important Information:
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Trading Strategy with Head and Shoulder
The Head and Shoulder pattern trading strategy is rather simple. In most cases, traders place a sell stop below the neckline and then estimate the take-profit by measuring the distance between the head and the neckline. The stop-loss is then placed at the right shoulder. This is usually a relatively safe approach considering that it is difficult to predict where the right shoulder will move.H&S pattern in stock trading
Like other chart patterns, it is possible to use the Head and Shoulders to trade stocks. A good example of this is in Peloton stock shown below. As you can see, the stock rose to $140 and then pulled back to $93. It then rose to $170, forming the head. The stock then rose to $125 and then formed the right shoulder. Therefore, in the long term, there is a chance that the stock will break out lower.
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