A head and shoulders pattern is commonly used in technical analysis. A specific chart formation indicates a bullish to bearish trend reversal. The pattern appears as a baseline with three peaks, the outside two being close in height and the middle being the highest.
The head and shoulders pattern is one of the most reliable chart patterns and is thought to be a strong indicator of an impending reversal. The two most common head and shoulder patterns are inverted and regular. The inverted pattern indicates a bearish reversal, while the regular pattern indicates a bullish reversal.When price action creates a peak (the head), followed by a higher peak (the right shoulder), and then a lower peak, the head and shoulders pattern emerges (the left shoulder). When the price action falls below the neckline, the pattern is complete. The neckline is formed by drawing a line from the back of the head to the left shoulder.
When it forms in an uptrend, the head and shoulders pattern is a bearish reversal signal, and when it forms in a downtrend, it is a bullish reversal signal.The primary distinction between the two types of head and shoulders patterns is that the inverted pattern has a higher low between the head and left shoulder, whereas the regular pattern has a lower low between the head and left shoulder.
How to Apply the Pattern
The head and shoulders pattern is a reliable indicator of a market trend reversal when used in trading. However, before attempting to trade with this pattern, new traders must be familiar with the fundamentals of technical analysis and chart patterns.
The first step is to recognize the head and shoulders pattern in the chart. This can be accomplished by seeking a baseline, or support line, with three peaks. The middle peak should be the tallest, and the two outer peaks should be roughly the same height.
After identifying the head and shoulders pattern, traders must wait for the neckline, or resistance line, to be broken. This indicates that the bullish trend has given way to the bearish trend.Traders can now open a short position or sell their assets. To protect against false breaks, stop loss orders should be placed below the neckline.
Take Profit orders can be placed at previous support levels as well as Fibonacci retracement levels. A Fibonacci retracement is a tool used by traders to determine likely support and resistance levels using Fibonacci ratios.
