Head and Shoulders Reversal Pattern
One of the most popular patterns in technical analysis is the head and shoulders pattern. The head and shoulders pattern could work either as a reversal pattern or a continuation one. We will look at both –
We will discuss the head and shoulders reversal pattern for a rally first as opposed to the inverse head and shoulders reversal pattern seen on bear runs since the latter is a mirror image of the former and mostly the same principles would apply.
The first point to remember is that the head and shoulders pattern is a long term pattern as reversal patterns take longer to form than continuation patterns. Natural laws of physics tell us that it takes more effort to reverse the direction of a thing in motion rather than slowing it down.
The first formation of the head and shoulders pattern would be the left shoulder. We know in an uptrend the peaks and troughs are ascending. However, in this scenario, the peaks and troughs gradually start to lose momentum. The left shoulder forms a new peak 1, where the distribution begins causing prices to move down to 2. Point 2 could be a 50% or 66% retracement level of the original move to point 1 or a support point on the trendline.
We don’t know yet whether this is the left shoulder and could continue to be a buy at the retracement. On the next move up, the price breaks the previous high of 1 to form a peak at point 3. Here one might observe a low volume causing the move from 2 to 3 or rapid selloff at 3 such as a quick price drop, maybe a reversal bar at the top cautioning the trader that selling is stronger at 3 and there seems to be a lack of buying interest.
The next move is crucial. The fall from 3 down to 4 now retraces almost 100% and stops close to point 2 the start of the previous move. This 100% retracement forms the head of the pattern. The line drawn from 2 to 4 forms the neckline. The neckline forms a support for the next up move to point 5. What’s noticeable about point 5 is that it does not rise above the head or point 3 the peak.
The failure to rise above 3 and light volumes from points 4 to 5 signifies a new downtrend. The previous trend line that supported the initial rally, trend line 1 now acts as a resistance for the down move. At this point, the longs start liquidating realizing that the market is not rallying further and a move sideways is quite possible next.
Now we had drawn the temporary support line from 2 to 4. This support line is called the neckline for obvious reasons and acts as a support for the right shoulder. If the neckline breaks the trend line and closes below this line, it constitutes a break of the neckline. This break on a closing completes the head and shoulder reversal pattern. Players can now expect a new downtrend. Selling should now intensify on the break of the neckline.
A return move back to the neckline is quite possible. Notice that this neckline, which was once a strong support now acts as a resistance. Players who have not initiated shorts are waiting for the return move to start selling. The return move, however, may not be seen if the breakout from the neckline is violent. If the prices drop rapidly with heavy volumes the price might not retrace back to the neckline.
The last point to note about the head and shoulders is the minimum price objective. As we have seen from other patterns that volatility of prices within the pattern are used to measure the minimum distance prices are likely to travel on the breakout. Therefore for the head and shoulders simply measure the distance from the neck to the head top and project that from the breakout point.
Next, we study the inverse head and shoulders pattern