What Does the Head And Shoulder Pattern Mean?

If you have just started investing, mastering and learning chart patterns can be overwhelming for you. With these charts, the market always gives signals of a reversal pattern. These patterns are crucial in the stock market since they allow traders to predict future price movements by representing market trends and potential reversals.

The chart pattern head and shoulders is one of them that indicates a trend reversal. Let us understand the head and shoulder pattern in more depth and what it indicates.

What is the Head and Shoulder Pattern?

A head-and-shoulder pattern is a candlestick chart pattern which includes 3 consecutive peaks. In this pattern, the second peak, which is the ‘head’, is higher than the other two peaks, which are considered as the ‘shoulders’.

This pattern is considered a technical analysis indicator which helps investors identify a bearish trend reversal. This signals that the stock is likely to end its bullish trend and enter a bearish trend, where the stock price will dip from its current level.

Understanding these trends on a chart can provide valuable entry and exit points for investors, helping them take advantage of the market reversals.

A head and shoulders pattern takes shape when the stock price reaches its peak after increasing for some time and then dips before moving upwards. Subsequently, the stock price goes higher than the previous peak price to form the shape of the pattern’s ‘head’ and then falls to the initial base.

The stock price reaches the peak one more time around the level of the first peak and falls back. This makes the ‘shoulder’ of the pattern.

How Does the Head and Shoulder Pattern Function?

In a head and shoulder pattern, the stock price rises to take the shape of the first peak. Then, it goes down to the neckline, which is the base before rising past the first peak to form the second peak, which is the head.

Afterwards, the price falls again to the neckline before going up to form the third peak. From here, it dips abruptly below the neckline, indicating a price reversal from bullish to a bearish trend.

Key Insights to Get From the Head and Shoulders Pattern

As you have come across the meaning of the head and shoulder pattern and how it works, let us assess the key insights from it:

1. The left shoulder indicates that the selling pressure quells the prevailing buying pressure temporarily.
2. The right shoulder shows that buyers drive the price upward once again, but the price fails to increase to its previous peak.
3. The head indicates that the buying pressure increases once again and surpasses the previous peak before the selling pressure takes over.
4. The neckline is the support level below which the price drops at the end of the third peak, which confirms the bearish reversal.

Using the Head and Shoulders Pattern for Trading

A head and shoulder pattern is one of the best technical indicators that signals that the ongoing bullish trend is likely to end, and the stock price will drop due to the rise of selling pressure. Follow the steps below to trade using this pattern:

Step 1: Identification

Identify a head and shoulders pattern and ensure it is perfectly formed and has all 3 peaks, including the left shoulder, the head, and the right shoulder. The neckline must also be clear, which connects the lows between the head and shoulders.

Step 2: Neckline Break

The neckline break happens when the price breaks below the neckline. It is crucial to trade only after the neckline break, since it is highly risky to enter a trade before it.

Step 3: Entering Trade

When the price closes below the neckline, you must enter a short position or sell by exiting a long position. If you have a high-risk tolerance, you may enter trades just after the formation of the right shoulder, as you can anticipate the neckline break.

Step 4: Setting Stop-Loss

You must place a stop-loss since trading with a head and shoulders pattern can be risky. Putting a stop-loss just above the right shoulder is also necessary, since this can be an appropriate resistance price level. You can put a closer stop-loss above the neckline if you have entered the trade after the break and if you have a lower risk appetite.

Step 5: Profit Target

For better trading, you must set a profit target beforehand. You can determine an appropriate profit target by analysing the gap between the top of the head and the neckline. After the gap analysis, subtract this gap distance from the neckline breakpoint to set your profit target.

Advantages of Using the Head and Shoulder Pattern

1. Versatality

   A head and shoulder pattern is so versatile that it can be useful across different markets, including stocks and forex.

2. Profits From Movements

   This pattern unfolds over a particular time frame, enabling traders to profit from substantial market movements.

3. Defined Risks

   Seeing this pattern, traders can define entry and exit points, with appropriate stop-loss levels. This reduces confusion and manages risks effectively.

4. Easy Recognition

   Experienced traders can easily spot this pattern.

Disadvantages of Using the Head and Shoulder Pattern

1. Neckline Movement Ambiguity

   Traders might find the neckline shifts sometimes. This can cause uncertainty among traders regarding pattern confirmation.

2. Challenge of Novice Traders

   Beginners may struggle to recognise a head and shoulder pattern, which can lead to missed trading opportunities.

3. Unfavourable Risk-to-Reward

   Sometimes, traders might find some situations where they can see an unfavourable risk-to-reward ratio. This can pose challenges in achieving profitability.

4. Large-Stop Loss Gaps

   This pattern can result in large stop-loss distances, which increases the risk exposure for traders.

Final Thought

As a beginner, the head and shoulder pattern is crucial to understand. This pattern indicates the end of a bullish trend and the start of a bearish reversal. This makes it one of the most easily recognisable chart patterns.

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Frequently Asked Questions

1. What does a head and shoulders pattern signal in trading?

A head-and-shoulders pattern indicates a bearish reversal chart pattern, which shows that an uptrend is ending and a downtrend is likely to start.

2. Is head and shoulders a bullish or bearish pattern?

A head and shoulder pattern is considered bearish. It signals that a bullish trend is ending soon, and a bearish reversal may start soon.

3. How can you spot a head and shoulders pattern in a chart?

To identify a head and shoulders pattern, you must look for three peaks in an uptrend. The middle peak is the ‘head’, which is the highest, and the other two peaks are the ‘shoulders’, which are lower in height. Additionally, there is a ‘neckline’ which connects the two troughs between these peaks.

4. Can you use a head and shoulders pattern in intraday trading?

Yes, a head and shoulder pattern can be used in intraday trading with shorter timeframes. However, patterns on longer timeframes are considered more reliable.