What Is The head and shoulders chart pattern?

The head and shoulders pattern is an important tool used in technical analysis. It is a distinctive chart formation that predicts a transition from a bullish to a bearish trend. The pattern visually appears as a baseline with three peaks, with the two outer peaks showing similar highs, while the central peak is the highest.

The head and shoulders pattern develops as follows: The stock price rises to a peak and then returns to the base of the previous upward movement. The price then rises beyond the previous peak, creating the “head,” and then drops back to the original base. Finally, the stock price peaks again at approximately the level of the first peak within the formation, before falling again.

The head and shoulders pattern is known as one of the most reliable trend reversal indicators. It is classified among the various topping patterns that indicate with varying degrees of precision, signal the impending conclusion of an uptrend.

Understanding the Head and Shoulders Pattern 

The head and shoulders pattern consists of four main components:

Initial shoulder formation: After a prolonged bullish trend, the price rises to a peak and then later pulls back to form a bottom.

Head formation: The price rises again, forming a second peak that significantly exceeds the height of the initial peak. This is followed by another decline.

Second shoulder formation: The price experiences a third rise, but this time only reaches the level of the first peak, before falling again.

Neckline: The neckline is determined by drawing a line connecting the two lows formed after the first and second peaks, or in the case of an inverse head and shoulders, the two peaks formed after the first and second troughs.

In this pattern, the first and third peaks are referred to as the shoulders, and the second, higher peak constitutes the head. The line connecting the first and second troughs (or the two peaks in an inverse pattern) is called the neckline.

Head and shoulders top 

The “Head and Shoulders top” is a bearish reversal chart pattern in technical analysis. Here’s a breakdown of what it means:

Reversal Signal:

Indicates a potential shift from an uptrend to a downtrend.

Structure:

It consists of three peaks:

Two outer peaks (the “Shoulders”) that are roughly equal in height.

A central peak (the “Head”) is higher than the shoulders.

A “Neckline” connects the troughs between the peaks.

Confirmation:

The pattern is confirmed when the price breaks below the neckline.

Once the price breaks the neckline, the price is projected to continue in a downtrend.

Implications:

It indicates that buying pressure is weakening, and selling pressure is increasing.

It is a signal for traders to consider exiting long positions or entering short positions.

Reliability:

It is considered one of the most reliable trend reversal patterns.

Basically, the head and shoulders indicates that the uptrend is likely to come to an end and that the downtrend is about to begin It starts.

Head and shoulders low 

The “head and shoulders low” is the bullish counterpart to the head and shoulders top. Here’s a breakdown of what it means:

Bullish Reversal:

Indicates a potential reversal from a downtrend to an uptrend.

Structure:

Consists of three troughs:Two outer troughs (the “shoulders”) that are roughly equal in depth.

A central trough (the “head”) that is lower than the shoulders.

A “neckline” connects the peaks between the troughs.

Confirmation:

The pattern is confirmed when the price breaks above the neckline.

Once the price action breaks the neck line, the price is projected to continue in an up trend.

Implications:

It indicates that selling pressure is weakening, and buying pressure is increasing.

It’s a signal to traders to consider exiting short positions or entering long positions.

Reliability:

Like the head and shoulders top, it’s considered a reliable trend reversal pattern.

Basically, the inverted head and shoulders pattern indicates that the downtrend is likely to end, and an uptrend is about to commence.

What Does the Head and Shoulders Pattern Tell You? 

The head and shoulders chart pattern is known to depict a trend reversal from bullish to bearish and serves as a signal that an uptrend is nearing its end. It is considered by investors to be one of the most reliable trend reversal patterns.

In terms of the reliability of the head and shoulders pattern, the standard entry point is determined by the breakout of the neckline, with a protective stop loss placed above the right shoulder in a market top scenario, or below the right shoulder in a market bottom scenario. The profit target is determined by measuring the vertical distance between the highest and lowest points of the pattern, which is then added to the breakout price of the market bottom, or subtracted from the breakout price of the market top. While this pattern does not guarantee an infallible results, it offers a systematic approach to market trading, underpinned by logical price action.

Support and resistance levels

“Support” and “resistance” are two distinct levels on a price chart that act to limit price fluctuations in the market. A support level represents a price threshold where declines are consistently stopped and subsequent upward rebounds occur, while a resistance level refers to a price ceiling where advances typically stop and are followed by subsequent downward retracements ensue. These levels are manifestations of the interaction between supply and demand; an excess of buyers over sellers can push prices upward, while an excess of sellers over buyers tends to depress prices.

The frequency of price interaction with either level is directly related to the reliability of the level in predicting future price paths. These levels often develop into psychological barriers for traders, who tend to initiate buy or sell orders upon their attainment, thereby reinforcing their efficacy.

A transient penetration of a support or resistance level, followed by a rapid price reversal, indicates a mere test of that level. Conversely, a sustained breach of a certain level indicates that price action will continue until a new support or resistance level is established.

Moving averages (MA) 

In the world of finance, a moving average (MA) is a stock indicator that is widely used in technical analysis. The primary function of a stock moving average calculation is to smooth out price data by generating a continuously updated average price.

This calculation reduces the impact of random short-term price fluctuations over a specified time frame.

Simple moving averages (SMAs) use a direct arithmetic average of prices over a specified time period, while exponential moving averages (EMAs) assign a higher weight to more recent prices compared to those of earlier periods.

Stop losses and guaranteed stop losses 

– A stop-loss order is a strategic trading tool used to mitigate potential losses or lock in profits on a fixed position. Traders use stop-loss orders to effectively manage their exposure to risk. Specifically, a stop-loss order is an instruction to liquidate a position by executing a buy or sell order in the market when the price of a security reaches a predetermined level, known as the stop price.

– A guaranteed stop loss order is a risk management mechanism, specifically a stop loss order, designed to ensure the final closure of a trading position at a pre-determined price. It is a vital tool to mitigate potential losses during periods of high market volatility.

Guaranteed stop-loss vs basic stop-loss

The difference between a standard stop loss and a guaranteed stop loss lies in the guarantee of execution. A basic stop loss is an order to liquidate a position when it reaches a predetermined price, which is less favorable than the prevailing market price. Despite its value, it is susceptible to slippage, which may result in the order being executed at a price that deviates from the specified level. In contrast, a guaranteed stop loss works similarly to a basic stop loss, with the crucial difference being that it guarantees execution at the exact price specified by the trader, irrespective of rapid market fluctuations.

Trailing stops

A trailing stop loss order is a stop loss order that adjusts dynamically with the market price, protecting accumulated profits from potential market reversals.

Much like the ease of piloting an airplane in flight compared to the complexity of landing, the essence of profitable trading lies in the exit strategy. Noticing a market reversal, and thus reducing or eliminating profits from a previously successful trade, can be a challenging experience. However, discerning the optimal exit point within a trending market remains a critical dilemma.

This is where implementing a trailing stop loss order becomes essential. The goal is to identify a methodology that strikes a balance between allowing a profitable position to extend its gains and protecting those gains from reversing, without triggering a stop loss prematurely due to natural market volatility.

This is particularly prominent in trend-following strategies, where the basic principle is to capitalize on the prevailing trend of the market throughout its duration.

Advantages and Disadvantages of the Head and Shoulders Pattern 

Advantages of the Head and Shoulders Pattern:

– Easy to recognize by experienced traders: This pattern is easily recognized by experienced traders due to its distinctive formation.

– Clear profit and risk Parameters: Precise entry levels for both short and long positions are defined, along with specific stop loss distances, when the pattern is confirmed.

– Potential for making significant profits from market volatility: Due to the extended time frame of the Head and Shoulders pattern, significant market volatility can be leveraged for profit.

– Universal application across markets: This pattern is effective in both forex and stock trading environments.

Disadvantages of the Head and Shoulders Pattern:

– Difficulty for novice traders to identify: The neckline may not always be perfectly horizontal, which can lead to misinterpretation by less experienced traders.

– Possible large stop loss distances: Extended downward price movements can result in large stop loss distances.

– The neckline may appear to be moving: A retest of the neckline after a breakout can create the illusion of movement, causing confusion among traders.

In conclusion, the head and shoulders pattern, despite its power, requires careful observation and understanding of its fine details. Mastering its identification and application can greatly enhance your trading strategy.

With Naqdi, you can use of guaranteed stops for spread betting or CFD positions. This is achieved by setting a stop-loss order within the deal ticket and explicitly selecting the ‘guaranteed stop’ option from the provided drop-down menu.