Head & Shoulders Everywhere!

We once heard the late Yale prof., Stephen Ross, say that “if you stare at the clouds long enough,  you can see pink elephants.”

We kind of feel that way, though not completely, about seeing patterns in stock charts.

Head & Shoulders.png

This entry was posted in Equities, Technical Analysis, Uncategorized and tagged , , , . Bookmark the permalink.

2 Responses to Head & Shoulders Everywhere!

  1. JPorter631@aol.com says:

    What does the “head and shoulders” pattern mean? John

  2. macromon says:

    JP, This a bit of some fun sarcasm, but that you asked;

    The head-and-shoulders pattern is one of the most popular and reliable chart patterns in technical analysis. And as one might imagine from the name, the pattern looks like a head with two shoulders.

    Head and shoulders is a reversal pattern that, when formed, signals the security is likely to move against the previous trend. There are two versions of the head-and-shoulders pattern. The head-and-shoulders top is a signal that a security’s price is set to fall, once the pattern is complete, and is usually formed at the peak of an upward trend. The second version, the head-and-shoulders bottom (also known as inverse head and shoulders), signals that a security’s price is set to rise and usually forms during a downward trend.

    Both of these head and shoulders have a similar construction in that there are four main parts to the head-and-shoulder chart pattern: two shoulders, a head and a neckline. The patterns are confirmed when the neckline is broken, after the formation of the second shoulder.

    The head and shoulders are sets of peaks and troughs. The neckline is a level of support or resistance. The head and shoulders pattern is based on Dow Theory’s peak-and-trough analysis. An upward trend, for example, is seen as a period of successive rising peaks and rising troughs. A downward trend, on the other hand, is a period of falling peaks and troughs. The head-and-shoulders pattern illustrates a weakening in a trend where there is deterioration in the peaks and troughs.

    Head and Shoulders Top
    Again, the head-and-shoulders top signals to chart users that a security’s price is likely to make a downward move, especially after it breaks below the neckline of the pattern. Due to this pattern forming mostly at the peaks of upward trends, it is considered to be a trend-reversal pattern, as the security heads down after the pattern’s completion.

    This pattern has four main steps for it to complete itself and signal the reversal. The first step is the formation of the left shoulder, which is formed when the security reaches a new high and retraces to a new low. The second step is the formation of the head, which occurs when the security reaches a higher high, then retraces back near the low formed in the left shoulder. The third step is the formation of the right shoulder, which is formed with a high that is lower than the high formed in the head but is again followed by a retracement back to the low of the left shoulder. The pattern is complete once the price falls below the neckline, which is a support line formed at the level of the lows reached at each of the three retracements mentioned above.

    Inverse Head and Shoulders (Head-and-Shoulders Bottom)
    The inverse head-and-shoulders pattern is the exact opposite of the head-and-shoulders top, as it signals that the security is set to make an upward move. Often coming at the end of a downtrend, the inverse head and shoulders is considered to be a reversal pattern, as the security typically heads higher after the completion of the pattern.

    Again, there are four steps to this pattern, starting with the formation of the left shoulder, which occurs when the price falls to a new low and rallies to a high. The formation of the head, which is the second step, occurs when the price moves to a low that is below the previous low, followed by a return to the previous high. This move back to the previous high creates the neckline for this chart pattern. The third step is the formation of the right shoulder, which sees a sell-off, but to a low that is higher than the previous one, followed by a return to the neckline. The pattern is complete when the price breaks above the neckline.

    The Breaking of the Neckline and the Potential Return Move
    As seen from the above, the head-and-shoulders pattern is complete when the neckline is broken; the trend is then considered reversed, and the security should be heading in a new direction. The point of breakout is when most traders following the pattern would enter the security.

    However, the security will not always just continue in the direction suggested by the pattern after the breakout. For this reason it’s important to be aware of what is known as a “throwback” move. This situation occurs when the price breaks through the neckline, setting a new high or low (depending on the pattern), followed by a retreat back to the neckline.

    This move back to the neckline is considered to be a test of the pattern and the newly reversed support or resistance. Remember that when a trend shifts (or a reversal pattern is confirmed), what was once support now become resistance, and vice versa. In the case of an inverse head-and-shoulders pattern (as shown in the chart above), the neckline represented a level of resistance for the security before it broke out. Upon the security moving above the neckline to confirm the pattern, the restrictive neckline becomes support for any move back up.

    While it can be alarming to see a security move in the opposite direction of the trend suggested by the pattern, it isn’t all that bad. The reason being that the successful test of this new level of support or resistance helps to strengthen the pattern and its suggested new direction. So, it’s important to wait for the pattern to test out and not sell out too quickly – before the pattern makes its bigger moves.

    Read more: Analyzing Chart Patterns: Head And Shoulders http://www.investopedia.com/university/charts/charts2.asp#ixzz4qgiiIjLd

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