The head-and-shoulders chart pattern is a popular and easy-to-spot pattern – once a trader is aware of what they are watching for. The pattern appears on all times frames and can therefore be used by day and swing traders as well as investors. Entry levels, stop levels and price targets make the formation easy to implement as the chart pattern provides important and easy-to-see levels. (Every time an investor talks about getting in low or picking entry and exit points, they are paying homage to these men. Check out The Pioneers Of Technical Analysis.)
TUTORIAL: Learn To Analyze Chart Patterns
What the Pattern Looks Like
First, we’ll look at the formation of the head and shoulders pattern and the inverse head and shoulders.
- Seen at market tops.
- Formation of the pattern:
- Left shoulder: Price rise followed by a left price peak, followed by a decline.
- Head: Price rise again forming a higher peak.
- Right shoulder: A decline occurs once again, followed by a rise forming the right peak which is lower than the head.
- Formations are rarely perfect, which means there may be some noise between the respective shoulders and head.
- Seen at market bottoms.
- Formation of the pattern:
- Left shoulder: Price declines and moves higher.
- Head: another Decline occurs to a lower level.
- Right shoulder: Price then moves higher and moves back lower, but not as low as the head.
- Again, formations are rarely perfect. There may be some market noise between the respective shoulders and head.
|Figure 2: SPY Daily Chart – Inverse Head and Shoulders (April 2010-Sept. 2010)|
Placing the Neckline
The first step is to locate the left shoulder, head and right shoulder on the chart. In the standard head and shoulders pattern (market top), we connect the low after the left shoulder with the low created after the head. This creates our “neckline” – the yellow line on the charts. We’ll discuss the importance of the neckline in the following section. In a reverse head-and-shoulders pattern, we connect the high after the left shoulder with the high formed after the head thus creating our neckline for this pattern.
How to Trade the Pattern
It is very important that traders wait for the pattern to complete. One should not assume that a pattern will develop, or that a partially developed pattern will become complete in the future. Partial or nearly completed patterns should be watched, but no trades should be made until the pattern breaks the neckline. In the head and shoulders we are waiting for price action to move lower than the neckline after the peak of the right shoulder. For the inverse head and shoulder, we wait for price movement above the neckline after the right shoulder is formed.
A trade can be initiated as the pattern completes. Plan the trade beforehand, writing down the entry, stops and profit targets and noting any variables that will change your stop or profit target.
The most common entry is when a breakout occurs – the neckline is broken and a trade is taken. Another entry point requires more patience and comes with the possibility that the move may be missed all together. This method involves waiting for a pullback to the neckline after a breakout has already occurred. This is more conservative in that we can see if the pullback stops and the original breakout direction resumes, but it also means the trade may be missed if the price keeps moving in the breakout direction. Both methods are…