Rather than using technical indicators to help spot high probability trade entry and exit points, some traders and investors prefer to utilize chart patterns for guidance in trade or investment decisions. Chart patterns come in all shapes and sizes and can potentially provide powerful trading signals. Some of the more commonly used chart patterns are double tops or bottoms, triangles, wedges and island tops or bottoms.
The head and shoulders pattern is also widely used and can be indicative of powerful market reversals.
What is a Head and Shoulders Pattern?
The head and shoulders pattern describes the following price action in a market:
A. A stock rises to a peak and then declines.
B. The stock rises above the previous peak and then declines.
C. The stock rises again but fails to rise to the second peak and then subsequently declines.
In other words, a head and shoulders is simply when a stock makes a high then drops, makes another higher high, then drops and finally makes a lower high before declining.
On a chart, the pattern resembles a head with a shoulder on either side, hence the name.
Why Is This Pattern Important, and How Can I Use It?
A head and shoulders pattern may be useful in any market from stocks to futures to forex. It can be used for determining tops and bottoms, as a head and shoulders bottom is simply inverted. A potential target on a head and shoulders reversal is the distance from the head to the low point (or high point) of either shoulder. This distance is then added or subtracted from the neckline.
In addition to showing possible powerful market reversals, one of the other primary benefits of the head and shoulders pattern is the ease with which stops and profit targets may be placed. Using standard methodologies for trading the pattern, a trader or investor can make sure that the P&L potential is in line with their risk tolerance.
When looking to initiate a position, it’s imperative to allow the pattern to complete beforehand. Stops may be placed initially just above or below the right shoulder.
While the head and shoulders pattern can potentially provide very powerful trading signals, the pattern is not full proof. These patterns can and do fail, and traders must always manage risk.
