Sep-02-2024
What is the head and shoulders pattern?
The head and shoulders pattern consists of three peaks: the left shoulder, the head, and the right shoulder. The left shoulder forms after a significant uptrend, followed by a price decline. The head is created when the price rises again to a higher peak, and then drops once more. Finally, the right shoulder forms when the price rises but fails to reach the height of the head, then declines again.
This pattern indicates a potential reversal in the current trend. In a standard head and shoulders pattern, it signals a transition from an uptrend to a downtrend.
Key to trading this pattern is the neckline, which connects the low points of the left shoulder, head, and right shoulder. The neckline's slope can be either upward, downward, or horizontal. Traders look for the price to break below the neckline which then signals the start of a new downtrend.
The Psychology Behind the Pattern
The head and shoulders pattern is more than just a visual chart formation; it reflects underlying market psychology and investor behavior.
The formation of the left shoulder occurs when a strong uptrend shows signs of weakening. Whereas the trend still looks healthy from the left shoulder to the head, the trend-continuation from the left shoulder to the head is often weaker and the price doesn't advance as much as it did in the early trend.
However, the first true signs of trend weakening occur when the right shoulder forms below the head. The lower high is an important warning sign to all bullish market participants.
Furthermore, the drop from the head to the neckline also requires careful analysis. The drop from the head to the neckline is often a strong bearish price reaction, typically much stronger than past bearish correction moves during the uptrend. In the example below, the strong bearish market phase after the head is highlighted in the black box.
The neckline represents a psychological support level. When the price breaks below this line, it confirms the shift in market sentiment. Traders interpret this break as a signal that the prevailing trend has reversed, prompting them to adjust their positions accordingly.
Most head and shoulders-based trading strategies suggest looking for trading opportunities around the neckline. We will explore some variations shortly.
