Head and Shoulders

Definition

In technical analysis, the “Head and Shoulders” pattern is a formation that indicates a reversal of a trend. The pattern consists of three peaks: a higher peak (the head) sandwiched between two lower peaks (the shoulders). A “Head and Shoulders Top” signifies a bearish reversal (prices are expected to fall), whereas a “Head and Shoulders Bottom” (also called an inverted Head and Shoulders) signifies a bullish reversal (prices are expected to rise).

Head and Shoulders Top

The “Head and Shoulders Top” is often seen at the end of an upward trend. Here is the breakdown:

Left Shoulder - A peak followed by a decline.
Head - A higher peak followed by a decline.
Right Shoulder - A peak lower than the head but similar in height to the left shoulder, followed by a decline.
Neckline - A trendline drawn through the lows of the two shoulders.

When the price falls below the neckline, it confirms the pattern and signals a bearish trend.

Head and Shoulders Bottom

Conversely, the “Head and Shoulders Bottom” pattern appears at the end of a downward trend, suggesting an upcoming bullish reversal.

Examples

Stock Market Example: If a stock price has been consistently increasing and forms a head and shoulders top pattern, traders might interpret this as a signal that the stock price is about to fall, triggering a short sell.
Currency Trading: In Forex trading, the appearance of a head and shoulders bottom pattern could indicate that a currency pair is gearing up for an upward move, leading traders to go long (buy).

Frequently Asked Questions (FAQs)

Q1: How reliable is the Head and Shoulders pattern?

A1: The reliability of the pattern can vary, but it is generally considered one of the more dependable chart patterns. Its success rate tends to improve when used with other technical indicators.

Q2: Can the Head and Shoulders pattern be used in different time frames?

A2: Yes, this pattern can be applied to various time frames, from intraday charts to weekly or monthly charts.

Q3: What is the “neckline” in a Head and Shoulders pattern?

A3: The neckline is the trendline drawn through the low points (for a head and shoulders top) or high points (for a head and shoulders bottom) of the two shoulders.

Q4: Can false signals occur with the Head and Shoulders pattern?

A4: Yes, like any technical analysis tool, false signals can occur. It’s recommended to use this pattern in conjunction with other indicators for confirmation.

Q5: What should I do if I see a head and shoulders pattern?

A5: If confirmed, traders usually place trades in the direction suggested by the pattern – either going short in a head and shoulders top or going long in a head and shoulders bottom.

Technical Analysis: The study of price trends and patterns to predict future movements in stock prices.
Bullish: Expectation or prospect that prices will rise.
Bearish: Expectation or prospect that prices will fall.
Chart Pattern: A recognizable configuration of price movement identified using a series of trendlines and curves.

Online References

Suggested Books for Further Studies

“Technical Analysis of the Financial Markets” by John Murphy
“Technical Analysis Explained” by Martin J. Pring
“Japanese Candlestick Charting Techniques” by Steve Nison

Fundamentals of ‘Head and Shoulders’: Technical Analysis Basics Quiz

### What characteristic features make up a standard head and shoulders top pattern? - [x] Three peaks with the middle peak being the highest. - [ ] Two peaks of equal height. - [ ] A single peak followed by a steady decline. - [ ] A continuous upward trend with no decline. > **Explanation:** A head and shoulders top pattern is defined by three peaks: the first and third peaks are of similar height, and the middle peak is the highest. ### What type of trend does the head and shoulders top pattern indicate? - [x] A bearish reversal trend. - [ ] A bullish continuing trend. - [ ] A neutral movement in price. - [ ] Continuous trend with increasing volatility. > **Explanation:** The head and shoulders top pattern is a bearish reversal signal indicating that the stock price is expected to fall. ### When is a head and shoulders top pattern confirmed? - [ ] When the price reaches the peak of the head. - [ ] When the left shoulder is formed. - [x] When the price breaks below the neckline. - [ ] When volume increases significantly during the formation of the head. > **Explanation:** The pattern is confirmed when the price drops below the neckline drawn from the lows of the two shoulders. ### What additional technical factor can increase the reliability of a head and shoulders pattern? - [x] Volume confirmation. - [ ] A flat moving average. - [ ] The Relative Strength Index (RSI) being overbought. - [ ] High daily trading volume. > **Explanation:** Volume confirmation, particularly where volume decreases during the formation of the head and shoulders, and then increases on the breakdown, can increase the reliability of this pattern. ### An inverted head and shoulders pattern is considered a signal for what type of trend reversal? - [ ] Continuing bearish trend. - [ ] Continued sideways trend. - [x] Bullish trend reversal. - [ ] A neutral sentiment in the market. > **Explanation:** An inverted head and shoulders pattern indicates a bullish trend reversal, suggesting that prices are expected to rise. ### Can the head and shoulders pattern occur in different time frames? - [x] Yes, it can occur on intraday, daily, weekly, and monthly charts. - [ ] No, it is only applicable to daily charts. - [ ] It only appears on intraday charts. - [ ] It is most reliable on monthly charts only. > **Explanation:** The head and shoulders pattern can be identified in different time frames, making it a versatile tool in technical analysis. ### Which term describes the line connecting the lows of the two shoulders in a head and shoulders top pattern? - [x] Neckline. - [ ] Support line. - [ ] Resistance line. - [ ] Trendline. > **Explanation:** The neckline is the trendline connecting the lows of the two shoulders in a head and shoulders top pattern and is critical to confirming the pattern. ### What should traders do upon confirmation of a head and shoulders top pattern? - [x] Consider selling or shorting the security. - [ ] Buy more shares in anticipation of a rise. - [ ] Hold the security expecting further consolidation. - [ ] Ignore the pattern and focus on news announcements. > **Explanation:** Upon confirmation, most traders consider selling or shorting the security, as the pattern suggests a bearish trend. ### What is the main difference between a head and shoulders top and an inverted head and shoulders pattern? - [ ] The volume used in the patterns. - [ ] The indicators applied. - [x] The direction of the trend reversal signaled. - [ ] The type of assets they are applied to. > **Explanation:** A head and shoulders top signals a bearish reversal, whereas an inverted head and shoulders pattern signals a bullish reversal. ### How does the shoulder height typically compare to the head in a head and shoulders pattern? - [ ] The shoulders are higher than the head. - [x] The shoulders are lower than the head. - [ ] The shoulders and the head are of equal height. - [ ] The shoulder height varies without a specific pattern. > **Explanation:** In a head and shoulders pattern, the shoulders are typically lower than the head, forming the distinctive shape.

Thank you for exploring the ‘Head and Shoulders’ pattern with this comprehensive entry and quiz. Continue honing your technical analysis skills and best of luck in your trading endeavors!