Head and Shoulders Reversal Pattern
The head and shoulders pattern is one of the most notorious technical patterns. When traded properly its statistical success rate is very high. Although the complexity of pattern often causes impatient traders to anticipate the formation and front run the breakout.
What makes the head and shoulders pattern so complex, is it combines all possible components of a technical pattern: volume, trendlines, rounding, support (resistance lines), and the breakout. The head and shoulders pattern is mostly known as a reversal pattern found at a major top or bottom, however what fools many traders is this pattern can also developed as a failed formation within a consolidation rather than at the end of a trend. Because of this, a trade should only be taken after the pattern is complete and all technical requirements have been realized. When traded properly, the success rate is high, reaching the projected target nearly 85% of the time.
The head and shoulders pattern is a series of three well-defined peaks which consist of a left shoulder, a head, and a right shoulder. Both the left and right shoulders must be lower than the head, but the two shoulders do not have to be the same height. While symmetry is preferred, sometimes the shoulders end up out of whack. There are times where more than two shoulders form. When this happens it’s called a complex head and shoulder pattern. This pattern also has the same performance and failure rate. Occasionally, a two-headed variety appears, it’s performance and failure rate remain the same. If the middle peak (the head) of an alleged head and shoulders topping pattern fails to be greater than 5% above the other two peaks then it’s probably a triple top pattern and vice versa (if the middle trough is less than 5% below the other two troughs) in a bottoming pattern. If a horizontal trendline can be drawn across three peaks (resistance) while simultaneously drawling a horizontal trendline across three troughs (support) then chances are it’s a rectangle pattern (trading range).
Volume will play an important part as we walk through the construction of the pattern. The left shoulder begins to form at the end of an extensive move (uptrend). This is where volume should be the highest. Volume will often surge into the peak of the left shoulder then decrease through out the pattern. After the peak of the left shoulder is formed (high point of the uptrend), price will slide down building the left shoulder. The low of the decline should remain above the uptrend line and will be the start of the neckline.
The head is then formed as price rally off the low of the left shoulder making a new high. This move usually happens on lower volume than the advance of the left shoulder. The decrease in volume combined with the new high of the head should draw caution. After peaking, the low of the ensuing move downward will often break below the uptrend line and mark the second point of the neckline. This break below the trendline is now the second warning of caution as the uptrend is now in danger and the topping pattern has begun form.
The neckline is a support line (trendline) that is formed by connecting the two low points of the peaks. The first low point is formed where the left shoulder ends and the head begins. The second low point is formed where the head ends and the right shoulder begins. Although the neckline is often horizontal, it can also be downward or upward sloping depending on the relationship between the two low points.
The right shoulder begins to form when price rallies from the second low point of the neckline forming a lower high. The peak of this high will be lower than the head (lower high) and is usually in line with the peak of the left shoulder. The decline from the peak of the right shoulder should then break below the neckline. Front running this potential signal could be dangerous. There are times when the right shoulder does not completely form and price fails to break below the neckline. Instead, price surges higher and breaks out above the peak of the right shoulder resuming the prior uptrend.
The breakout is required to complete the head and shoulders formation. The breakout signal is triggered when price breaks below support of the neckline after completing the right shoulder. The breakout should occur in a convincing manner on increased volume (decreased volume is not a sign of failure, it just happens less frequently). Once support (neckline) is broken, it is not uncommon for this support level to turn into resistance as pullbacks are frequent (60%-67% of the time). The pullback offers a second chance to sell.
After the breakout is triggered, an implied price target can be found by measuring the distance from the neckline to the top of the head. That distance is then subtracted from the neckline to reach a suggested price target.
Head and Shoulders Reversal Pattern
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