Trading stocks can be a rather intriguing business. As a professional technical analyst will tell you; all instruments trading on an exchange, be it stocks, futures, commodities, or indices often form patterns. These patterns are governed by human behaviour and keep appearing with changing levels of similarity. While two patterns may not identically resemble each other, several recognisable features keep recurring, which helps traders identify and predict the movement of prices and trends. One such typical pattern recognised by professional traders is the head and shoulders pattern. Here’s a detailed guide on this immensely recognisable stock trading pattern.
What is the head and shoulders pattern?
Regarded as one of the most consistent trend reversal patterns, the head and shoulders chart pattern is primarily a price reversal pattern. It helps traders in a market identity an upcoming trend reversal after a trend has seemingly exhausted itself. The reversal essentially predicts or signals a bullish to a bearish trend reversal, indicating that an uptrend has ended. The pattern appears as a baseline, consisting of three peaks in which the two peaks outside are close in height whereas the one on the middle is the highest. It resembles a distinct, ‘left shoulder’, a ‘head’ and a ‘right shoulder’, along with a neckline formation.
Understanding how the head and shoulder chart pattern works
The head and shoulders chart pattern is formed when the price of a stock rises to a peak, after which it declines back to the base of its former move-up. Next, the stock price once again rises, this time above its previous peak and forms the “nose”, before declining back to its original base once again. Subsequently, the price of the stock rises once again, but to the first level, i.e. the initial peak of formation, before it declines back to the neckline or base of the chart pattern one more time.
What is the inverse head and shoulders pattern?
The inverse or inverted head and shoulders pattern is the opposite of the regular head and shoulders pattern. It is also regarded as the head and shoulder bottom due to the inversion. The inverted pattern becomes apparent when the price action of the security exhibits a few recurring characteristics. For instance, the inverted pattern appears when the price of a stock falls to a trough before it rises again. The pattern reappears when the stock price falls below the prior trough and rises again before a final drop. But the rise is not as far or as much as the second trough. Upon making the final trough, the stock price begins heading upwards, towards the resistance which is found close to the top of the previous troughs.
Decoding the inverted head and shoulder pattern
Like the regular head and shoulders pattern, the inverse head and shoulders pattern is a reliable pattern that can indicate that a downward trend could reverse to an upward trend anytime shortly. When this happens, the price of the stock reaches three consecutive lows and is separated by short-term, passing rallies. Of these, the first and third troughs (the shoulders) are marginally shallow, whereas the second trough (the head) is the lowest. The final rally, which appears after the third dip indicates the reversal of the bearish trend and the fact that stock price is most likely to keep moving upward.
Six reasons why the head and shoulders pattern is deemed reliable by traders
No trading pattern is usually perfect; it does not always work. Despite this, many traders believe that the head and shoulders chart pattern works theoretically. Here are some reasons why traders consider this chart pattern more reliable than most others.
1. As stock prices fall from a market high (i.e. the head), traders can tell that sellers have begun entering the market, which is characterised by less aggressive buying.
2. As the neckline is being approached, many buyers who made purchases during the final wave higher or on the right shoulder rally are now being proven wrong and are facing huge losses. This large group of buyers are now ready to exit their positions, which, in turn, drives the prices close to the profit target.
3. The stop, which is above the right shoulder in the chart pattern, is logical since the trend has now shifted downwards. Remember that the right shoulder is at a lower high as compared to the head, which is why it is unlikely to be broken till the uptrend resumes.
4. For the profit target, there is the assumption that buyers, who are wrong and bought the stock at a bad time, may have little choice but to exit their position. This results in the creation of a reversal of a somewhat similar scale to the topping pattern, which recently occurred.
5. Now, the neckline becomes the point where a large group of traders start experiencing the pain of their investment and have little choice but to exit their positions. This situation further pushes the price of security towards the price target.
6. Finally, the volumes of the stock traded can also be watched. During an inverse head and shoulder pattern or market bottoms, traders would typically like the stock volumes to expand while the breakout occurs. This situation demonstrates the increased interest in buying that in turn, can move the price of the stock towards the target. On the other hand, a decreasing volume indicates that buyers are not interested in the upside move, which warrants a bit of scepticism.
As is apparent, the head and shoulders chart pattern, along with the inverted pattern is rather easy to read and understand. With a little practice and help from Angel Broking advisors, you too can start learning and analysing the various chart patterns. Reach out to our team of trading experts at Angel Broking for investment and trade analysis information.