What do Head and Shoulders Pattern Indicate in a Chart

Introduction

Any intraday trader who looks at charts daily may have come across the head and shoulders pattern. This is a useful trend reversal pattern spotted on a chart that signals the trader to buy or sell. Equally useful is the inverse head and shoulders pattern.

The Head and Shoulders Chart

A head and shoulders pattern on a chart is read as a trend reversal pattern. It is typically characterised by a first peak, the left shoulder, followed by a higher peak or the head and then a third lower peak, which is the right shoulder. The lowest points of each of these peaks can be connected to form a neckline.

Let’s understand each of these components of the head and shoulders trading pattern:

1. The left shoulder or the first peak occurs when bullish traders push the stock price higher. However, this only lasts for a while before prices fall again.

2. Once again, bullish traders return to push the prices higher than the first peak, causing the head. Prices don’t sustain at this level and decline to the point that’s at or near its previous low.

3. The right shoulder or the third peak forms once again as share prices as the stock price rallies once again but fails to reach its previous high before falling again.

4. The neckline is drawn by joining the lowest points of the head and shoulders chart pattern. If a stock’s price goes below this line, it’s a strong indication that the pattern has broken and you need to exit the position.

A head and shoulders chart signifies a bullish-to-bearish trend reversal. It means that an upward trend is coming to its end and perhaps a good time to sell your position in the stock.

Additional Read: Getting Started with Intraday Trading

The Inverse Head and Shoulders Pattern

In technical analysis, the inverse head and shoulders pattern is a reverse of the regular head and shoulders chart pattern. This too has a left shoulder, a head and a right shoulder; only, it’s inverted. It is spotted by a price dropping to a new low and rising temporarily, forming the left shoulder. The bears swoop in and push the prices to another low, lower than the previous one, followed by a temporary high. This forms the head. And once more, the right shoulder is formed by bears pushing the price lower, but not lower than the head. The highs of the left shoulder and head connect to form the neckline.

The inverse head and shoulders pattern indicates that a downward trend is reaching its end and there’s a bearish-to-bullish trend reversal. This may be a good time to buy the stock you are analysing.

Additional Read: What is a Bull Market?

Signal Confirmation

There are two things to keep in mind while trading the head and shoulders or inverse head and shoulders pattern. First, even if a stock’s price breaches the neckline, it’s not a confirmation of the trend unless the following two factors also align:

1.  Volume: The volume of shares trading indicates the strength behind the pattern. A sudden rise in volume when the price dips below or rises above the neckline suggests that the selling or buying pressure could get intense. If the volume does not support the trend, there are no guarantees whether the trend will sustain.

2.  Timeline: Usually, confirmation of the trend is stronger when the uptrend or downtrend pattern is at least twice as long as the distance between the shoulders.

Additional Read: Five suggestions for intraday trading

Takeaway

Reading the head and shoulders pattern correctly can be a great trading tool for novices and experienced investors. Once you identify the patterns appropriately, you can be more confident executing your trades. Also, remember to look for other confirming indicators to support the trend. To begin your trading journey, register for an account with ICICI Direct investment app.