What is Head and Shoulder chart Pattern?
Head and Shoulder is a chart pattern, formed by price action, with three swing tops placed side by side. It is very profitable reversal chart patterns. It is very reliable with 90% probability. This is created when there is a major profit booking in an uptrend.
They are the pressure areas in a stock chart, which may be a major resistance area, or it may even be a major target area. Here most traders book profit. And short selling begins. The trend changes from uptrend to downtrend. The support trend line of this pattern is an almost horizontal line connecting the two swing bottoms of the pattern.
It is so named because the pattern is in the form of a bust of a man, with central higher swing top resembling head and lower two swing tops on its either side resembling shoulders. Hence the name Head and Shoulder Chart Pattern.
Trend is your friend. Dance with the friend. Tune to the trend.
There are two great forces which move the price up and down. They are demand and supply. Head and shoulder is the result of extraordinary increase in supply over demand for the stock.
These are pressure areas in an uptrend. These are major target areas or major resistance areas where most traders wish to book profit. Here uptrend changes into downtrend.
In an up trend the price keep making higher high swing highs and higher high swing lows. As the target area or the resistance area is approached there is increased selling. As the supply increases the price falls down forming a swing high which is higher than the previous swing high. This swing high forms the head of this head and shoulder chart pattern formation. The previous swing high which is lower than the present swing high forms the left shoulder of this pattern.
Because of extraordinary increase in supply over demand for the stock, instead of falling 50% to 60% of previous swing range, the price falls almost to the level of the previous swing low which is the next immediate support zone.
As the price reaches the support area many traders wants to buy stocks because it is not only a bargain price in view of previous price rise, but also it is ideal to buy just above the support. So there is an increase in the demand for the stock and the price rises.
Although many traders are buying and the price is rising, it is not backed by smart money. Major funds are not participating. This time the price does not rise above the previous swing high. As it rises half way through selling pressure increases and the price falls making a new swing high which is lower than the previous swing high. This forms the right shoulder of this head and shoulder formation.
Between the three swing tops which form the head and shoulders of this pattern, there lies two swing bottoms. A trend line connecting the lowest points of these swing lows and extended to right forms the support line for this pattern. This line is termed as neck line of head and shoulder formation.
Study the chart given below.
This chart shows a Bearish Head and Shoulder Chart Pattern which is the bearish reversal pattern in an uptrend.
Pattern trading is one of the strategies of making money in stock trading. Among the chart patterns head and shoulder chart pattern formation gives us the opportunity to cover our long position and enter a short trade. These trades will have high rate of success.
What is invisibly going on in the market is very well expressed on the visible chart. The formation of head tells us that there is heavy selling of the stock. The falling swing of the head, instead of taking support at 50% or 61.8%, falls below 78.6% which is an indication of the underlying weakness.
Next the price fails to make higher high above the head and forms a lower swing high. Lower low swing high tells us that the market is not in an uptrend.
As the price falls to make the right shoulder, the price faces the support of the neck line of the head and shoulder pattern. When it breaks this support and falls below the previous swing low a down trend begins. By definition down trend is marked by lower low swing lows and lower low swing highs.
The moment you see a stock making an head and shoulder chart pattern cover all your long position and get ready to go short below the neckline. Protect this short trade by placing a stop loss buy order above the right shoulder.
Once the price breaks below neckline, 60% of the time it pulls back to test the neckline. Neckline was earlier support area which has now turned into resistance area after the price has fallen below it. Once the price falls after testing the neckline resistance, move the stop loss buy order to just above the swing high formed at the neckline.
The minimum target for this short trade is equal to the maximum height of the head measured from neckline and applied below the neckline from the break out point. Though this is the minimum target, many times the reward will be many times this which increases the risk to reward ratio.
Study the chart given below.
This chart shows a Bearish Head and Shoulder Chart Pattern which is the bearish reversal pattern in an uptrend. The price has fallen four times its minimum target. This chart is same as above chart continued in time. Here the risk to reward ratio is 1:5.
Head and shoulder without pullback performs better than the one with pullback. Tall or narrow patterns perform better than short or wide ones. Patterns which break out with heavy volume outperform those which breakout with less volume. Patterns with a horizontal neckline or down sloping neckline perform better than those with up sloping neckline.
There are many more chart pattern formation used in pattern trading. Some of them are listed below. You may click on the name of each chart pattern listed below to learn and understand more about them.
Continuation Chart Patterns