What is a Head and Shoulders Pattern?
This pattern is easy to spot: a higher middle head above two lower shoulders on either side. This could signal the end of a bullish market. Because this pattern forms over the course of several periods before it clearly emerges, it is easy to spot once it does and gives you time to act on it.
Peaks and valleys
This pattern tracks price peaks and valleys in three distinct phases. The left shoulder shows the price rising until it hits a peak, and then it falls. This happens again for the head but it peaks significantly higher. In the third phase, the price pushes up but stays below the head before it falls. This can be interpreted to mean that while bullish support is strong, it is waning and will likely drop off soon.
The same pattern inverted can also indicate the reverse – that the market will reverse course in an upward trend. Look for a falling price that bottoms then spikes up. The next cycle shows an even lower bottom before spiking up again. The third time this happens, the bottom is once again less severe that the immediately previous cycle, indicating the sell off momentum is slowing down.
Supporting the neck
When analysts speak of “support” they are referring to strategic areas for placing orders. Supported levels tend to be longer lasting price points, while resistance implies a price point that is less likely to be maintained. In the head and shoulders scenario, traders look for the neckline to locate their trading sweet spot. Connect the lowest point of the left shoulder to the lowest point after the head to find the neckline. For an inverse pattern, connect the highest points of the left shoulder and the area after the head.
Ready, set, order!
When trading based on this pattern, it's important that you see a complete pattern before making your move. As you see it develop, plan for the scenarios you're likely to accept in view of your trading goals. Once it completes, you're in position to place your orders.
This pattern is one of the most popular and easiest to use. Although no pattern is a perfect predictor, this one is generally pretty accurate, hence its popularity.