The head and shoulders chart pattern, which shows a baseline with three peaks, the middle peak being the highest, is a common and easy-to-spot pattern in technical analysis. It is mainly used to detect a bullish-to-bearish trend reversal.
The pattern can be employed by all sorts of traders and investors because it appears in all time periods. The chart pattern gives crucial and immediately visible levels, making entry levels stop levels, and target goals simple to apply.
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Head and Shoulders pattern
We'll start with the head and shoulders pattern and then go on to the inverse head and shoulders pattern.
Pattern formation (as seen at market peaks):
As you can see, in this pattern, there is a price rise, followed by a dip (left shoulder) and a peak (head) and a dip to the low of the left shoulder and a peak (right shoulder) to the highs of the left shoulder and a drop below the low of the left shoulder and the head. By joining the lows of the left shoulder and the head, you can get the neckline.
Inverse Head and Shoulders
Pattern formation (as seen during market bottoms):
A price drop followed by a rise (left shoulder), followed by a deeper fall and a rise to the same level (head) and a drop to the lows of the left shoulder and a breakout (right shoulder) from the high of the head and left shoulder. The highs of the left shoulder and the head form the neckline.
How to Profit from the Pattern
Traders should always wait for the pattern to finish because a pattern may not develop at all and the price may move in the opposite direction. Patterns that aren't completed yet should be kept an eye on, but no trades should be made until the price breaks the neckline.
After the peak of the right shoulder, we look for the price of a stock to move lower than the neckline. After the right shoulder has formed, we wait for the price to move over the neckline for the inverse head and shoulders to show up.
When the pattern is done, a trade can be initiated when the neckline is broken. Plan your trades with stops and targets.
Another way in requires more patience and the risk that the move won't be capitalised at all. After a breakout, this strategy is all about waiting for a pullback to the neckline. This is safer because we can watch to see if the pullback ends and the original breakout direction stays the same.
Putting Your Stops in Place
In the head and shoulders pattern, your stop-loss order can be placed slightly above the right shoulder. Alternatively, the pattern's head can be employed as a stop, but this carries a significantly higher risk and so diminishes the pattern's reward to risk ratio. In the inverted pattern, the stop-loss order can be placed slightly below the right shoulder. The stop can be placed at the head of the pattern once more, but this increases the trader's risk.
Choosing Your Profit Targets
The price differential between the head and the low point of either shoulder is the pattern's profit target. The difference is then deducted from the neckline breakout level (at a market peak) to determine a downward price target. The difference is added to the neckline breakout price to create an upward price target for a market bottom.
Between recognising the breakout and attaining the appropriate profit target, investors may have to wait a long time—up to many months. Real-time monitoring of your trades can help you predict their outcomes better.
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