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The behaviour underlying the “Head & Shoulders” classical chart pattern in technical analysis
The Head and Shoulders chart pattern holds prominence as a well-known and broadly acknowledged pattern within the realm of technical analysis. It is used to forecast possible changes in trends within financial markets. It’s named for its visual resemblance to a human head and shoulders. This pattern is observed on price charts and is said to provide insight into the psychology of market participants.
The Head and Shoulders pattern consists of three main parts:
1. Left Shoulder
This is the first peak on the chart. It’s usually formed during an uptrend when prices rise to a certain level before retracing slightly.
2. Head
The second peak, which is the highest point of the pattern. It typically represents a temporary surge in buying pressure during the continuation of the uptrend.
3. Right Shoulder
The third peak, similar to the left shoulder but usually slightly lower in height. This peak also signifies a retracement in prices after the head has formed.
Also see: Inverse Head & Shoulders classical chart pattern
The psychology behind the Head and Shoulders pattern revolves around shifts in market sentiment:
1. Left Shoulder
At this point, buyers are still in control of the market, pushing prices higher. However, some investors might start to take profits, leading to a small retracement.
2. Head
As prices climb higher and reach a peak, more investors see this as a great opportunity to sell and lock in profits. This causes a considerable pullback as selling pressure increases.
3. Right Shoulder
The market tries to recover from the sharp decline after the head, but the buyers’ momentum is weaker. Traders who missed the earlier sell-off might see this as a chance to sell, leading to another dip in prices.
The key aspect of the Head and Shoulders pattern is the “neckline,” a trendline drawn connecting the troughs between the left shoulder, head, and right shoulder. Once the price breaks below the neckline, it’s often seen as a confirmation that the pattern is complete and a reversal might be imminent. This breakdown below the neckline suggests that the buyers have lost control, and the selling pressure has become dominant.
The psychology of traders during the formation of the pattern and the subsequent breakdown of the neckline can be summarized as follows:
Formation
During the pattern’s formation, traders who bought during the earlier uptrend might become increasingly anxious as prices fail to sustain their previous highs. At the same time, short-term traders might spot the potential reversal and start positioning themselves for a downtrend.
Breakdown
When the price breaks below the neckline, it triggers a rush of selling orders. Traders who were holding on to positions in hopes of a rebound might start panic-selling to minimize their losses. This increased selling pressure can intensify the downtrend.
It’s important to note that while the Head and Shoulders pattern can be a powerful tool for identifying potential reversals, not all instances of this pattern lead to trend reversals. Traders and analysts often combine chart patterns with other technical indicators and fundamental analysis to increase the accuracy of their predictions.
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How to trade the “Head & Shoulders” classical chart pattern
Trading the Head and Shoulders chart pattern involves identifying the pattern, confirming its completion, and then executing appropriate trading strategies based on the expected trend reversal. Here’s a step-by-step guide on how to trade the Head and Shoulders pattern:
1. Identify the Pattern
- Look for a clear uptrend in the price chart.
- Identify the Left Shoulder, Head, and Right Shoulder peaks, along with the neckline connecting the troughs.
- Make sure the pattern is well-defined and not distorted.
2. Confirm the Pattern
- Wait for the price to break below the neckline after the formation of the Right Shoulder. This neckline breakout is a crucial confirmation of the pattern’s completion.
- The breakout should ideally be accompanied by increased trading volume, indicating strong participation by traders.
3. Set Entry Points
- After the neckline breakout, wait for a retest of the neckline from below. This retest can offer a potential entry point.
- Another approach is to wait for a small pullback after the initial breakdown. This pullback can provide an opportunity to enter at a better price.
4. Place Stop-Loss Orders
- Set your stop-loss order just above the Right Shoulder’s high or slightly above the neckline. This level acts as a potential resistance if the price tries to reverse back upward.
Also see: Stop Loss . . . and its importance in trading – Some ways of setting up stop loss levels
5. Determine Price Targets
- Calculate the pattern’s projected price move by measuring the distance from the Head to the neckline and then subtracting this value from the neckline breakout point. This gives you an estimated target for the downward move.
- You can also use other support levels, previous lows, or Fibonacci retracement levels to set potential price targets.
6. Risk Management
- Determine your risk tolerance and position size based on your trading strategy and overall portfolio management.
- Ensure that your potential loss (from your stop-loss) aligns with your risk management strategy.
Also see: How to determine one’s tolerance to risk?
7. Monitor Trade
- Once you’re in the trade, closely monitor price movement and volume. If the price continues to move in your expected direction, you might consider trailing your stop-loss to lock in profits as the price moves lower.
8. Exit Strategy
- As the price approaches your target(s), consider taking partial profits to secure some gains while letting a portion of your position run to capture further potential downside.
Also see: Some ways of setting up take profit levels
9. Adapt to Market Conditions
- Market conditions can change, and not all Head and Shoulders patterns lead to successful reversals. Be prepared to adapt your trading strategy based on new information and price action.
Remember that while the Head and Shoulders pattern can be a reliable reversal indicator, no trading strategy is foolproof. Always use proper risk management techniques, and consider combining the pattern with other technical indicators or fundamental analysis to increase the likelihood of success. Additionally, practicing on demo accounts or with smaller position sizes can help you gain experience before committing larger amounts of capital.