Understanding the Head and Shoulder Pattern (Hint: It Has Nothing to do with Dandruff)

Apurva Sheth
Have you ever looked down and, to your horror, noticed a fine sprinkling of white flakes on your shoulder?

I admit it's happened to me.

Now, I don't know about you, but when I think about dandruff, I can't help but think of Head and Shoulders shampoo (some products have a way dominating effect not only the markets but our minds...or should I say head?).

Then, of course, the analyst in me can't help but think of the 'head and shoulder' reversal trading pattern.

Almost all market technicians and traders take the pattern very seriously. Just as one flake on a dark suit can be a warning sign of more to come, the formation of a head and shoulder pattern could very well warn the death of an uptrend and the beginning of a bear phase.

A head and shoulder is a three-peaked chart pattern resembling, as the name would suggest, a head and two shoulders.

The middle peak, normally the highest, is the head. To either side of the head is an outside peak, generally lower than the head but roughly equal in size. These are the left shoulder (LS) and right shoulder (RS). The lows between the head and right and left shoulders are supports. Connect the supports with a line and you have what we call neckline of the pattern.

The Head and Shoulder Price Pattern
Source: Profit Hunter

I have written to you before about candlestick patterns and their stages. Price patterns and candlesticks go through the same stages. The three stages of a candlestick pattern are the trend followed by the pattern and finally confirmation.

Price patterns go through the same stages but include more components since they're more complex than candlestick patterns. But don't worry: I will explain all of them to you in a very simple and easy to understand language.

Let's have a look at each component of a head and shoulder price pattern.

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  1. Prior Uptrend
    Remember that the head and shoulder patter is a bearish reversal pattern. For a bearish reversal to take place, a well-defined uptrend must first be in place. A higher top-higher bottom formation or prices moving well along a rising trendline are signs of an established uptrend.

  2. Left Shoulder
    This is when a stock that was moving smoothly in an uptrend suddenly hits a supply zone and retraces lower. This retracement can be bigger than previous retracements along the uptrend. Until this point, higher volumes – a sign that the bulls are in control and are willing to pay higher prices to get a piece of the stock - confirms the uptrend. Volumes expand when prices go up and fall when prices go down.

  3. Head
    Prices again start moving higher after the initial retracement that forms the low of the left shoulder. They even move past the peak of the left shoulder. Prices moving past the previous high draws attention of people sitting on the fence. This pushes the prices further up but not much beyond the peak of the left shoulder. Prices suddenly take a U-turn when almost everyone is bullish on the stock. By this time, volumes have already taken a hit. Volumes do not confirm the new high by expanding further than what they were at the left shoulder. Prices move higher on the back of falling volumes. This suggests that the enthusiasm amongst buyers is decreasing. Drying up of volumes is generally a precursor to a fall. This is exactly what happens after prices have peaked out. The stock corrects and dips as low as the bottom of the left shoulder. This completes the head formation.

  4. Right Shoulder
    The stock starts moving higher after finding support around the lows of the peak of left shoulder and head. They bounce back to a level equivalent to the peak of the left shoulder but not as high as the head. Perhaps surprisingly, volumes do not pick up. The price advance in right shoulder takes place on volumes lower than the peak of the left shoulder and head. Price hits the supply zone again and forms a peak. Suddenly the stock is out of fuel. No one seems to be willing to buy the stock as everyone who could have bought the share already has. Now everyone is waiting for higher prices to sell their shares. Unfortunately, no one is willing to buy the stock at these prices. People holding the stock become impatient, and one by one, they start exiting the stock at market rates. This creates an excess of supply because there isn't any substantial demand for the stock. This eventually pushes the prices lower and completes the right shoulder.

  5. Neckline
    Prices now touch the horizontal support line drawn across the lows of left shoulder and head. This level acts as a support zone for the stock as many participants have witnessed the stock bounce back from these levels earlier.

  6. Break below neckline
    This is the last and final stage of the pattern. Once prices break below the neckline, the pattern is confirmed. The break below the previous supports attracts selling not only from those who bought in anticipation of a pullback from these supports but also from those who have bought the stock at higher levels. The break below the neckline also confirms a lower top lower bottom formation on charts. This is a classic Dow Theory signal of the beginning of a downtrend.

So that's about it for the head and shoulder pattern. Next time, using a real life example from my own research, I will show you how you can calculate price targets based on the head and shoulder pattern.

Have you traded a head and shoulder reversal pattern before? Share your views in the Club or share your comments here.

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1 Responses to "Understanding the Head and Shoulder Pattern (Hint: It Has Nothing to do with Dandruff)"
RAJKUMAR S D
19 Aug, 2015
Excellent explanation, but one request is that it should be explained with the practical example of any listed scrip which had adopted this pattern in the recent past with exact dates. Thanks with regards Like (2)
We request your view! Post a comment on "Understanding the Head and Shoulder Pattern (Hint: It Has Nothing to do with Dandruff)". Click here!