Guide To Head And Shoulders Pattern In Day Trading

Head & Shoulders: Bear Charms, Bulls Ordeal

In Stock market Head and shoulders is the most popular and reliable reversal pattern. The pattern forms by two upswing moves (shoulders) separated by one large upswing move (head). The two upswing moves need not be of same size. A novice stock market trader can analyze this pattern by trading apps and trading softwares.

The support line joining previous two swing lows is known as “neckline”. This neckline is critical in the development and confirmation of “head and shoulder” pattern. The neckline can either be horizontal or slanting.

Trading considerations: After the head and shoulder pattern is confirmed, one should enter shorts after break below the neckline. Break with high volumes enhances credibility of the trade. Post breakout; we target vertical distance between highest point of the head from neckline. This target is measured from the breakout point.

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Retest of neckline: After the break of neckline, often stock makes another attempt to the neckline. This can also be considered as good shorting opportunity for those who missed the sharp breakout earlier. One may sell on this upswing once there are hints of top-out. Target for this trade is same as discussed earlier.

There are two versions of the head-and-shoulders pattern:

The head-and-shoulders top is a signal that a security’s price is set to fall. This is “bears charm” while a real ordeal for bulls. This is the pattern we have discussed so far.
The head-and-shoulders bottom (or inverse head and shoulders), signals that a security’s price is set to rise after a long down move. Bulls may finally start loving the rally in the stock. Stock Trading consideration for the pattern remains similar.

Dow Theory: The head and shoulders pattern confirms to Dow Theory’s peak-and-trough analysis. An upward trend continues with successive rising peaks and rising troughs. However first threat to this “higherhighhigherlow” pattern ismet by the trough intervening head and right-shoulder.This trough often breaks the “higher-low” rule. This creates first doubt about the ongoing bull-run. However we still remain bullish to sideways on the stock.

Next the ensuing rally from this “double bottom” level fails to reach the previous swing high. This failure confirms the end of bullish bias. Bias now turns sideways. However, once the trough level is taken out (break below neckline), bias changes to bearish.

Volumes are an important element during progress of thisstructure. Overall volumes should fall as the pattern progresses. Highest volumes are observed at the left shoulder followed by head and then right shoulder.

Ideally one wants to see, subsequent rallies to loose volumes while successive down moves to relatively gain volumes.Considerations would be exactly opposite for reverse head and shoulder pattern.

Finally breakout below the neckline with high volumes gives more credence to the breakout. Higher the volumes at the breakout better would be expected performance.

Complex head and shoulder pattern is a pattern where the overall pattern has multiple left and/or right shoulders and/or head. Trading assessments and measurements, however, remain similar to a normal head and shoulder pattern.

Failed head and shoulder pattern: More often than not, a failed head and shoulder pattern is where neckline is not breached. This means trade wasn’t initiated and the pattern was never complete.

Rarely would it happen that the trade would lose after breaking neckline. But even in this case, our reward in any trade is far superior to the risk we are taking in a single trade. This gives us a significant trading edge. Mobile trading apps shows the pattern in a rightful manner.

Conclusion: Go short when price breaks below the neckline. Place a stop loss above the last peak. Go short again if price rallies back to neckline while placing stop loss above the resistance neckline. Target for these trades is verticaldistance between neckline and peak of “Head” measured from neckline breakout point. Stock Trading considerations remain same in case of bullish (inverse) head and shoulder pattern.

Apart from being a highly successful technical pattern, this pattern also provides high reward-to-risk ratio. However occurrence of the pattern is not as frequent as many would want to.