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Head and Shoulders Stock Pattern

The head and shoulders stock pattern is one of the most popular patterns used by technical analysts. The head and shoulders top appears as a three-peak pattern with the center peak the tallest of the three. You can also have more than one left and right shoulder in the formation. The important feature is the head that is taller than the shoulders on each side.

Head and Shoulder Pattern

The formation of a head and shoulders pattern normally begins after a nice rise in the stock share price. The left shoulder forms when there is a pull back in the price after rising to a new high or interim high. The price stops moving down after a brief drop in the price and it turns back up to a new high. The new high forms the head of the formation. Finally, the stock price turns down again before it reached the prior high forming the right shoulder.

The chart below of the DJIA or Dow Jones Industrial Average shows the formation of a well-defined head and shoulders stock pattern. In this case, two left shoulders and two right shoulders can be identified. This is fairly common and serves to further refine the head and shoulders top pattern.

Another feature of the head and shoulders stock pattern is the neckline that connects the bottom of the left and right shoulders. This neckline is offers a support level that investors use to trigger point to enter a short sale, to close long positions and/or add down side protection such as protective put options and covered calls. The neckline also helps to identify the potential drop in the price as defined by the measured move rule.

When a head and shoulders pattern forms with more than two shoulders, it is called a complex head shoulders stock pattern. However, the basics of a head and shoulders top remain the same.

Volume is an important indicator for many head and shoulder patterns. Usually the volume is higher on the left shoulder and with the formation of the head. Then volume tends to taper off as buying interest fades. However, there are times when volume on the right shoulder can rise significantly, especially on the moves down. When this takes place, it is a further indication the price of the stock is falling and you should take action to protect their capital.

Trading Head and Shoulder Patterns

Trading the head and shoulders stock pattern is a straightforward process. When you recognize the formation of the right shoulder, it is time to be ready to take action. If you are confident the formation is a head and shoulders top, you can close your long positions, sell shorts and take other actions to protect your capital. The low failure rate of this stock chart pattern allows you to take on some risk.

If you decide to short the stock when you encounter a head and shoulders top, a good place to place your initial stop is just above the neckline for shorts triggered by this level. If you decide to short just after the formation of the right shoulder and before the neckline has formed, then place your initial stop just above the high of the right shoulder.

The measured move for the head and shoulders pattern provides a good indication of how far the price will fall. To calculate the measured move you take the closing high of the head and subtract the middle of the neckline for the left and right shoulder. Take this difference and subtract it from the middle of the neckline to arrive at the target for the move down.

In the chart above, two measured moves can be calculated. The first one was for the upper left and right shoulders. 14,000 (the high of the head) – 12,000 (the middle of the upper neckline) = 2,000. 12,000 (the middle of the upper neckline) – 2,000 = 10,000. On the chart, 10,000 lined up with an earlier support line, so this could be a target.

However, since we had two left and two right shoulders, the proper measured move should use the lower neckline. In this case, the target from the measured move using the lower left and right shoulders was 8,000. It turns out that the DJIA fell to 7,000 before turning back up. While the measured move gave a higher target, it still gave target that allowed investors to protect their capital and make some money during the down trend. I like to use round numbers for these calculations as this rule is not designed to be absolute in its target.

Risks using Head and Shoulder Patterns

Consider the book by Thomas N. Bulkowski wrote Encyclopedia of Chart Patterns (Wiley Trading) only definitive study of chart patterns that includes statistical analysis of the success and failure of over 50 chart patterns. An excellent reference.

According to Bulkowski’s book, the Head and Shoulders pattern had only a 7% failure rate during the course of his study. As one of the lowest failure rates, this indicates that the head and shoulders stock pattern is a valuable tool. While all investing and trading incurs risk, when this stock pattern forms, you should be ready to employ the proper money management techniques to reduce your risk of loss.

Probably the biggest risk most investors face when they encounter a well-formed head and shoulders top is they fail to take heed and hold their stocks, hoping the market and their stock will not continue to go down. In this case, they are exchanging a well-founded trading discipline for hope that the bad news will not happen. Maybe by now you have recognized that the chart above accurately identified the rapid plunge in the stock market that began in early 2008 when the first right shoulder formed. Anyone who identified the development of the head and shoulders top and did not act suffered.

Conclusion

Be aware of the formation of a head and shoulders stock pattern, as they occur frequently. Moreover, they offer investors and traders a reliable chart pattern that has proven successful in the past. This chart pattern reflects the behavior of investors who are losing interest in a stock that shows up in the price and volume action.

As always, use proper money management techniques to protect your precious capital. They include trailing stops, closing part of all of your long positions on a sign of a move down and adding down side protection to reduce your risk of loss.


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