How To Use Head And Shoulders Chart Patterns

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by: Charles Schwab

Summary

A head & shoulders pattern may be an indicator that a major trend reversal has occurred.

This type of pattern could be a bearish indicator.

A head & shoulders can be used to help determine price targets.

A true head & shoulders pattern doesn't occur very often, but when it does, many technical traders believe it's an indicator that a major trend reversal has occurred. A standard Head & Shoulders pattern is considered to be a bearish setup and an "inverse" head & shoulders pattern is considered to be a bullish setup.

Pattern components

When this pattern is fully formed it is typically considered to be a significant reversal pattern. There are four components to the Head & Shoulders pattern that must be present in order to confirm the pattern has formed.

  1. Right shoulder
  2. Head
  3. Left shoulder
  4. Neckline break

Head and shoulders pattern

Many traders believe that looking at the price pattern alone does not give the whole picture and that volume also plays a key role in helping determine if the pattern is valid.

What the pattern signals

Pattern Type Pattern Signals
Head & Shoulders Top Bearish Reversal
Head & Shoulders Bottom Bullish Reversal

Pattern signals

Pattern time frame

The head & shoulders pattern can develop over virtually any time frame. However, most traders believe that patterns that take a longer time to form are more significant and more likely to identify a meaningful price reversal.

Longer Term Mid-Term Shorter-Term
6 months - 1 year + 1 month - 6 months 1 day - 3 weeks
YES YES NO

How a head & shoulders top pattern forms

The head & shoulders pattern plays out in a specific sequence as described below. The only real variable is how long it takes to complete each step in the sequence.

  1. Price is in a clear uptrend, then reaches a peak and starts to decline. This peak forms the "right shoulder" in the pattern.
  2. Price completes a brief decline and rallies again to an even higher peak. Price then begins to decline from this higher peak which forms the "head" in the pattern. Some traders consider this to be more significant if volume is noticeably lower during the rally to the peak forming the "head". Lower volume during this phase suggests that even though price is rising, there is a lack of conviction on the part of buyers.
  3. Price rallies for a third and final time, but fails to reach the high price achieved during the previous rally to the "head". From this third peak price declines again, in the process forming the "left shoulder" in the pattern. If volume is increasing as price moves back down towards potential support, some traders consider it to be a sign that the support level may not hold.
  4. A "neckline" is formed by connecting the low prices registered between the left shoulder and the head and the head and the right shoulder. Typically this line is not exactly horizontal.
  5. Price must break below the neckline in order to complete the pattern, thereby reversing the original trend. This price break is considered to be much more significant if it is accompanied by high and/or above average volume which indicates increased urgency on the part of sellers.

Pattern formation and completion

How an inverse head & shoulders bottom pattern forms

A head & shoulders bottom pattern is also commonly referred to as an "inverse" head & shoulders pattern because it resembles the traditional pattern simply flipped on its head.

  1. Price is in a clear downtrend, then reaches a trough and starts to advance. This forms the (inverse) "right shoulder" in the pattern.

  2. Price completes a brief advance and declines again to an even lower trough. Price then begins to advance from this lower trough which forms the (inverse) "head" in the pattern. Some traders consider this to be more significant if volume is noticeably lower during the decline to the trough forming the "head". Lower volume during this phase suggests that even though price is falling, there is a lack of conviction on the part of sellers.
  3. Price declines for a third and final time, but fails to reach the low price achieved during the previous decline to the "inverse head". From this third trough price advances again, in the process forming the (inverse) "left shoulder" in the pattern. If volume is increasing as price moves back up towards potential resistance, some traders consider it to be a sign that the resistance level may not hold.
  4. A "neckline" is formed by connecting the high prices registered between the left shoulder and the head and the head and the right shoulder. Typically this line is not exactly horizontal.
  5. Price must break above the neckline in order to complete the pattern, thereby reversing the original trend. This price break is considered to be much more significant if it is accompanied by high and/or above average volume which indicates increased urgency on the part of buyers.

Inverse pattern

Using head & shoulders pattern to help determine price targets

Another unique feature of the head & shoulders pattern for many traders is that it can be used to estimate a price target after the pattern is complete and the neckline is broken. To find the estimated distance of the subsequent price move after the neckline is broken, go back and measure the vertical distance from the peak of the head to the neckline. Then subtract this same distance down from the neckline beginning at the point where price first penetrates the neckline after the completion of the right shoulder. This gives the minimum objective of how far prices may decline after the completion of this top formation.

Price target using head & shoulders top pattern

  1. Measure the distance from the head to the neckline to determine the spread amount.

  2. Find the breakout point - where the outside of the right shoulder meets the neckline - and measure down the distance found in Step #1 to determine a potential downside price target level.

Price target chart

Price target: head & shoulders bottom

  1. Measure the distance from the head directly up to the neckline.

  2. Find the breakout point - where the outside of the right shoulder meets the neckline - and measure up the distance found in Step #1 to determine a potential upside price target level.

Head & shoulders bottom

Summary

A lot has to happen in order for a head & shoulders pattern to be completed. Not only do the events have to happen in a certain order but that certain order implies a particular interplay between bullish and bearish traders. A completed Head & Shoulders pattern indicates that bullish traders (or bearish traders in the case of an inverse head & shoulders pattern) have made multiple attempts to push price through to higher ground and were unable to do so. This is why many traders consider the head & shoulders pattern is considered to be an important reversal pattern.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.