The head and shoulders patterns provide one of the most reliable reversal signals. Why?
Simple: It's because of its popularity among traders. Since many traders monitor this pattern, the signal it provides becomes a self-fulfilling prophecy.
Because of its reliability, the head and shoulders pattern became one of technical traders' most popular chart patterns. This popularity makes this pattern a self-fulfilling prophecy.
Read more about the head and shoulders in this lesson. You'll walk through the basics of identifying this pattern, its other type, and its self-fulfilling signal.
A head and shoulders pattern signals a bullish-to-bearish trend reversal. This happens when the upward market is experiencing intense selling pressure, which pulls the prices down and up. This market movement ultimately forms the head and shoulders patterns.
When this pattern occurs, you'll notice three peaks: the first peak (left shoulder), the second and highest peak (head), and the third peak (right shoulder).
Also known as the outside peaks, the 'shoulders' in this pattern are the first and third peaks. These two peaks are close in height.
The valleys these two shoulders make are crucial as they provide you with the trend's significant support level.
How? You connect the lowest points of the two troughs—and you'll have your neckline. The neckline acts as the trend's support level because the price failed to trade below these levels.
The pattern is confirmed only when the price breaks this neckline (support level). However, remember that a single pattern is insufficient to trade a signal. It's best to use multiple indicators to supplement your analysis and ask the community to verify the signal.
Note: Since the head and shoulders pattern is a bearish reversal signal, a downward slope is considered a more reliable signal.
The head is the highest peak among the three points – it's in the center of the shoulders, thus, it's called the head.
This is the highest point at which the price will trade. If either of the first and second peaks is higher than the second peak, then you're not looking at the head and shoulders pattern.
The head SHOULD always be higher than the first and third peaks.
What Happens to the Market During this Pattern Formation
The formation of the head and shoulders patterns signifies that the long bullish trend is ending – due to selling pressure.
This selling pressure amidst the bullish trend resulted in the formation of troughs subsequently after peaks. These troughs form the neckline or the support level of the market.
The market's rise and fall happens three times to form three peaks (the head and two shoulders) and two troughs (once connected, the neckline).
With its trend reversal signal, spotting a head and shoulders pattern gives you valuable insights on profitable entry points for your short (sell) position.
Entry points should be placed below the neckline. Once the price breaks from the neckline, it confirms the reversal and will decline further. Don't place it above the neckline because the price may bounce back after hitting it.
For ensured profitability, target can be calculated by measuring the highest point the head traded to the neckline. This represents how low the price will dip after breaking below the neckline.
It could trade even lower than your target, but remember, your target should remain the same. Don't adjust your target. Don't be greedy.
The inverse head and shoulders pattern is the exact opposite of the head and shoulders pattern.
The formation of the inverse head and shoulders indicates that the long bearish trend is ending. Additionally, with the intervention of the buyers in the bearish market, this pattern suggests that the market will reverse.
Inverse head and shoulders have these three distinct characteristics:
The popularity of the head and shoulders pattern is the primary reason behind its self-fulfilling prophecy.
This pattern is globally considered, and when traders collectively trade the signal, it becomes self-fulfilling because the price will move accordingly. Basically, this happens because a large number of traders recognize and act on the same patterns, thereby influencing market behavior.
However, the self-fulfilling power of these indicators and patterns has limited or short-term effectiveness.
Retail traders, who mostly trade these patterns, have little influence on the market movement. While they can move it, big participants like banks, institutional investors, and hedge funds will bring the market to its usual trend.
Always confirm the accuracy of the pattern and its signal. You can use multiple indicators to supplement the analysis or join our community to verify the signal with your fellow traders.
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