We are not talking about shampoo here…
We all know chart patterns are critical tools for those involved with technical analytics to use. After all, a properly read pattern can yield a wealth of information that can help investors accumulate more wealth. But all technical analysts have to start somewhere when it comes to chart pattern reading, and it’s important that those new to the game pick a pattern that will provide them the most bang for their investment buck. For a lot of investors, a head and shoulders chart is precisely that kind of design.
What is a Head and Shoulders Pattern?
The head and shoulders pattern is one of the most popular chart patterns in the world of technical analysis. It’s also one of the most reliable patterns, which is why it makes for a good pattern for those new to technical analytics to utilize. As its name suggests, the pattern looks like a head that has two shoulders.
The pattern itself is considered a reversal pattern. When it’s created, it signals that the stock in question is likely going to move counter to the previous trend. It’s easy to imagine this pattern as something that predicts and upward trend because a person’s head and shoulders are on the upper part of his or her body. Indeed, this appearance does represent one of the versions relating to the head-and-shoulders pattern, something that’s known as the head and shoulders top.
But don’t be confused: while a head and shoulders pattern forms during an upward trend, a head, and shoulders top signifies that a stock’s price is ready to fall. The “head” in this case is typically formed at the peak of an upward trend.
There is a reverse of this version, called the head and shoulders bottom or inverse head and shoulders. It acts exactly like the head and shoulders top, except that the peak, in this case, signifies a stock is poised to rise. A head and shoulders bottom typically forms during a downward trend.
The Construction of a Head and Shoulders Pattern
Whether you’re dealing with a head and shoulders top or a head and shoulders bottom, there are four main components to the chart pattern that investors should know about. There are two shoulders, head, and neckline. The head and shoulders are relatively easy to pick out, as they are built up from a series of peaks and troughs. The neckline is a little tougher to spot, as it represents the level of support or resistance that’s present on a chart.
These components all work together to help technical analysts pick out various upward and downward trends. To put it simply, an increasing trend can be marked by detecting a period of successive rising peaks and rising troughs. On the flip side, a downward trend can be characterized by unearthing a period of falling peaks and falling troughs. Ultimately, this pattern can flesh out a weakening in a trend via peak and trough deterioration.
The Four Steps to a Head and Shoulder Pattern’s Trend Reversal
Spotting a trend reversal may appear as simple as watching a stock’s price tumble on a chart via a head and shoulders pattern. While it can be broken down to those basic elements, there is more to the pattern than a series of ups and downs.
There are four main steps involved for a head and shoulders pattern to complete itself and usher in a reversal. The first phase is the creation of the “left shoulder,” which is built when the stock in question rises to a new high and then retraces to a new low. The second step is the creation of the “head,” which happens when the stock reaches an even higher high, then retraces back toward the low that was formed by the left shoulder. The “right shoulder” is created in the third step, and it is formed with a high that is lower than the head’s high, which also reverts to the left shoulder’s low. The pattern finishes when the price of the stock falls below the neckline, which is the support line established by the level of the lows reached each of the previously mentioned trios of retracements.
These steps are in place regardless of what version of the head and shoulders pattern is manifested. When this pattern develops in a head and shoulders top, it signals the end of an uptrend. When it develops in a head and shoulders bottom, it signals the end of a downtrend.
The completion of the pattern is the element that is of highest interest to investors. When the stock pattern plunges below the line of support (or rises above the line of resistance), the trend is considered reversed, which is typically the point of entry a lot of investors will utilize.
With that being said, when a stock breaks through this entry point, there’s a good chance that it won’t continue its upward or downward trajectory in an exclusive fashion. There may be a situation commonly known as a “throwback” that could develop. This situation occurs when the price breaks through the neckline, only to retreat to the neckline. This hiccup doesn’t mean that the trend reversal is going to reverse entirely. Generally speaking, such movement is considered a “test” of the newly established line of support or resistance. There’s no reason to freak out when this throwback happens. In fact, savvy investors may suggest to ride the apparent storm out and let the effects of the throwback pass – doing so may cost the investor a bigger profit.
Using Peaks to Pique Your Stock Interest
The peaks and troughs associated with head and shoulders patterns may appear to be self-explanatory. However, by digging into the “why” of the pattern as opposed to merely accepting the visual, investors can get a much better, and more predictable, bead on a stock’s performance over a given time interval. It’s this kind of foresight that those just getting their feet wet in the fast-paced world of technical analytics can use to make the most informed decisions possible.