For technical analysts chart, is the all-important medium for making trading decisions. Those who can understand the signs of charts discover the way to the treasury while the others might end up losing their hard-earned money. Traders are always on the hunt for the trends or patterns that might result in some significant price movements or changes in the capital market. The Head and shoulders pattern is one of the most reliable trend reversal patterns for technical analysts.
The Head and shoulders pattern has three peaks with a baseline. The outer two peaks are called the “shoulders” and the highest of the three peaks in the middle is called the “head”. The head and shoulders pattern has a longstanding history for successfully predicting the bullish to bearish reversal trend. The three components of the head and shoulders pattern in the bullish reversal are formed as:
- First shoulder: The first shoulder is formed after a strong bullish trend where price rises but eventually declines to form a trough.
- Head: The head is formed when the price rises again making a new high but falls to the baseline.
- Second shoulder: The second shoulder is formed after the price takes off for the third time to the same height as the first shoulder and declines again.
The pattern is completed confirming the bullish reversal when the price falls below the baseline (or neckline). If the price cannot break below the neckline, it might be a false signal.
Sell: when the price breakout below the neckline after the formation of the last shoulder.
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The Head and Shoulders Inverse Pattern
The head and shoulders pattern formed in the opposite direction during the bearish trend is called the inverse head and shoulders pattern. The inverse head and shoulders pattern signals the market reversal of the bearish trend.
In the bearish reversal pattern, the head makes the lowest piece point, while the shoulders are shallower than the head. After the completion of the second shoulder, when the price breaks above the neckline, it confirms the end of the downtrend, and the bullish trend makes a major rally in the upward direction. The three dips provide a strong signal for the transition from a bearish to a bullish trend.
Buy: when the price breakout of the neckline after the formation of the last shoulder.
Stop-loss and Target Price
In the head and shoulders pattern and the inverse head and shoulders pattern, the target price and stop-loss price can be predetermined. With the inverse head and a shoulders pattern, the stop-loss can be placed either below the lowest price formed by the head or below the last shoulder. For the head and shoulders pattern with peaking highs, the stops are placed above the top of the head or at the last shoulder’s price point.
The target price can be simply calculated by measuring the vertical distance from the neckline to the head position. The target profit price is the vertical height measured. In the case of inverse head and shoulders pattern, if the distance between the peak head and the neckline is Rs. 100, then the target price is Rs. 100 above the neckline (baseline) of the pattern. This is the least target price for a successful reversal pattern, the traders might get more profit if the trend continues in the upward direction.
Head and Shoulders Pattern Interpretation
The Head and shoulders pattern is the result of the war between the bulls and the bears. The significance of this pattern is increased as it is supported by the theory of support level and resistance level. The three tops mean the buyers are trying to push the stock price above the resistance level and the neckline represents the support area. Thus, the stop-loss is placed above the top of the head for short-sellers.
In this sense, the best trading timing is when the neckline is stock breaks below the neckline. Those who missed the first trading opportunity at the breakout time can wait for retracement just above the neckline which may or may not occur.
Some of the other major reversal patterns are:
- Double tops and bottoms
- Triple tops and bottoms
- Saucer (rounding) bottom
The Head and shoulders pattern is one of the most accurate patterns in the unpredictable capital market that foretell the reversals. The longer time the pattern takes to form the more reliable it is. For example, the head and shoulders pattern formed in 30 days is less significant than the pattern formed in 150 days. The head and shoulders pattern is a sound and well-grounded pattern that the traders can rely on to make financial profits from the market. These patterns in technical analysis provide the traders with an edge over those who are just driven by the emotions of fear and greed.
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