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Questions & Answers
What is a Head and Shoulders Pattern?
The head and shoulders technical chart pattern is one of the best known and is also considered to be one of the most reliable chart patterns. It is a trend reversal pattern which lets traders know when a trend is coming to an end and is ready to move in the opposite direction. It gets its name from the fact that it looks like a head (the highest peak) bracketed by two shoulders (two smaller peaks). The head and shoulders begins during an uptrend, with price moving rapidly higher on significantly increased volume. After reaching a new high price it pulls back to form a trough. Price will then rise again on increased volume, but not as great as the first rally. This move will take price above the first peak. Price then declines to at or near the first trough, forming a second trough. A third rally occurs on lighter volume, with price only reaching the level of the first peak before declining again to the level of the trough. The first peak and the last peak are considered to be the shoulders, while the higher middle peak is the head. The troughs between these peaks are known as the neckline.
It’s also possible to get an inverted head and shoulders at the conclusion of a downtrend. This formation is built the same way, with three lows rather than highs. The inverted head and shoulders is an indication a downtrend is ending and an uptrend is beginning.
Why the Head and Shoulders Forms
The formation of the head and shoulders is nothing more than the story of the battle between bullish and bearish investors. The well defined ups and downs seen over and over again in this pattern are a classic retelling of market psychology. The first rally to a peak shows the declining momentum of the uptrend as a final wave of bulls is coming into the market. When no more new bulls appear, price declines to the first trough. At this point the bulls come back to the market to push prices higher, and at this point they could still maintain their hold on the uptrend. If price turns and drops back to the lows of the first trough it is clear the bears are beginning to take control. The bulls will try one more time to push price to a new high, but they will fail and leave the door open for the bears to take control of the market and begin a new downtrend.