Definition
The Head and Shoulders Pattern is a technical analysis term in finance, used to describe a specific chart formation that predicts a bullish-to-bearish trend reversal. The pattern is characterized by three peaks with the middle one, known as the head, being the highest and the two outside peaks (shoulders) being lower and roughly similar. It’s a highly reliable predictive tool in market price movements.
Key Takeaways
- The “Head and Shoulders” pattern is a chart pattern used in technical analysis. It depicts a specific price change layout of a financial instrument (such as a stock), illustrating a baseline (or “neckline”), with three peaks where the middle one (the “head”) is the highest and the two at the sides (the “shoulders”) are almost equivalent.
- This pattern is generally considered as a prediction chart pattern – when it’s fully formed it usually suggests a bearish outlook, implying that the financial instrument’s price could decrease beyond the pattern’s neckline.
- Traders usually make a decision when the pattern’s formation is complete i.e., when the price moves below the neckline after forming the second shoulder. The Head and Shoulders pattern is used for predicting the reversal of an uptrend in the market.
Importance
The Head and Shoulders Pattern is a crucial term in finance as it indicates a potential price reversal, specifically an imminent bearish turn.
This pattern, appearing on a price chart, is so-called due to its resemblance to a pair of shoulders and a head.
The ‘head’ is the peak price point sandwiched between two lower prices, termed as the ‘shoulders’. The line connecting the lows after each peak is termed as ‘neckline’. A full formation of this pattern often suggests that the security’s price is expected to fall as much as the height from the top of the head to the neckline, once it drops below the neckline level.
Thus, it provides analysts with a useful tool for identifying the right time to sell, take profit, or short a security, hence playing a vital role in investment and trading decisions.
Explanation
The Head and Shoulders Pattern is considered one of the most reliable trend reversal patterns in the world of technical analysis. Essentially, it signals the potential end of a bullish trend and the beginning of a bearish movement.
This pattern is used by traders and investors alike to predict a possible shift in the direction of the price action. Its purpose is to help establish ideal exit points for those who are long on a stock.
This prevailing pattern is formed by three peaks: the first and last peaks (or “shoulders”) are approximately at the same height, while the middle peak (the “head”) is higher. Ideally, the line drawn at the lowest points of the peaks (known as the “neckline”) should be descending, making the confirmation of the pattern even more reliable.
When the price drops below the neckline after forming the right shoulder, it provides a signal to sell or short the asset, depending on the trader’s strategy. Consequently, the Head and Shoulders Pattern is very useful in protecting investments and capitalizing on downward trends.
Examples of Head and Shoulders Pattern
The “Head and Shoulders” pattern is a chart formation that predicts a bullish-to-bearish trend reversal. Here are a few examples:
Bitcoin in 2017: Bitcoin demonstrated a renowned head and shoulders pattern in late
The coin experienced a run-up to nearly $20,000 (forming the head), before falling down and bouncing back to approximately $17,000 twice (forming the shoulders), then dropped significantly culminating the pattern. This action signaled a trend reversal from bullish to bearish.
The US Stock Market in 2007: Prior to the 2008 financial crisis, the US Stock Market formed a clear head and shoulders pattern. The S&P 500 peaked in October 2007 (forming the head). It then fell and rebounded in late 2007 and mid-2008 (forming the shoulders), before the major crash, highlighting the bearish reversal.
The Gold Price in 2012: The price of gold hit a high point in August 2011 (the head), then it fell and rose twice in a lower peak in November 2011 and February 2012 (the shoulders), then it dropped considerably. This price action was a clear representation of the head and shoulders pattern, predicting a change from an uptrend to a downtrend.
Frequently Asked Questions about Head and Shoulders Pattern
Q1. What is a Head and Shoulders Pattern?
A Head and Shoulders Pattern is a graphical representation of price movements that predicts a bullish-to-bearish trend reversal. It appears as three peaks with the middle peak (head) being the highest and the two other peaks (shoulders) being lower.
Q2. How is a Head and Shoulders Pattern identified?
The pattern is identified when the price creates three peaks at different levels. The head, being the highest peak, is in between the two shoulders which are lower peaks. These peaks are separated by two troughs, and the trend reversal is confirmed once the price goes below these troughs or the neckline.
Q3. What does a Head and Shoulders Pattern signify in trading?
This pattern is a strong indicator of a future bearish reversal. When a head and shoulders pattern emerges in a chart, it signifies that the asset’s price is likely to move against the previous trend, opening opportunities for a short sell position.
Q4. Can a Head and Shoulders Pattern indicate a bullish trend as well?
Yes, an inverted Head and Shoulders Pattern can indicate a bullish trend. It appears as a reversal pattern in a downtrend and is made up of three troughs. The middle trough is the deepest (the head) and the two either side are shallower (shoulders).
Q5. How reliable is the Head and Shoulders Pattern in predicting market trends?
This pattern is considered to be one of the most reliable trend reversal patterns. However, like all charting patterns, it doesn’t guarantee 100% accuracy in predicting the future direction of price movement. It should be used in conjunction with other analysis tools for more accurate predictions.
Related Entrepreneurship Terms
- Technical Analysis
- Bearish Reversal
- Volume
- Trend Line
- Neck Line
Sources for More Information
Sure, below are four reliable sources where you can learn more about the Head and Shoulders Pattern in finance:
- Investopedia: Offers a detailed explanation of the Head and Shoulders Pattern, including examples and charts.
- BabyPips: Provides tutorials about the Head and Shoulders Pattern along with other technical indicators.
- Daily FX: Gives real-time news about the forex market and articles explaining the Head and Shoulders Pattern.
- TradingView: Presents a platform for traders to discuss patterns like the Head and Shoulders and share trading ideas.
