Reversal Patterns. Head and Shoulders

Reversal patterns are the patterns in which the price trend reverses after breaking out from an opposite trend pattern. The Head and Shoulders pattern is one of the most popular and reliable reversal patterns. Read the article closely to understand this pattern better and use it next time.

The Head and Shoulders pattern occurs in an uptrend when a series of ascending peaks and lows lose momentum, and the trend loses its levels for some time. 

The volume of trading increases at this time, as the price rises again to a level lower than the previous peaks. Reaching the previous high point C becomes impossible (see the chart below.) The correction of this rise will occur from point D to two-thirds of the decline, to point E.

How the pattern forms

The price trend begins as expected, with no indication of any peak at point A. The trading volume extends to new high levels.

With the high volume at point B, the price undergoes a corrective decline to a lower trading level, which is an expected movement.

We notice: The trading volume at point C is slightly lower than the trading volume during the rise at point A. At this point, we should be cautious.

Then, at point D, the prices start to decline to point A, which is worrying, as the decline continues below the support level.

When the decline approaches the lowest price of point A, and if it extends below it, this is a warning of a reversal of the previous uptrend at point B.

For the uptrend to continue, the price must rise above the previous high point achieved by the previous uptrend. If the price fails to reach point E after point C, it achieves only half of what is required to start a new downtrend, which is the descending peak.

At point D, the main uptrend line is broken and indicates another warning sign.

Despite all the warning signs of the trend ending, the market may have changed direction from an uptrend to a sideways trend. You may need close buy positions but not to enter new sell positions.

Drawing the neckline

We draw a horizontal trend line under the last two lowest levels, and this line is called the neckline. (B and D are the turning points.) This line slopes upward in the Head and Shoulders pattern. Sometimes it may be horizontal and slope slightly downward in some cases.

The breaking of the neckline is the crucial factor in the Head and Shoulder pattern. The trading volume must increase when the neckline is broken.

If the price rebound develops to the neckline, point G or the lowest level of the previous reversal point at point D, after breaking the neckline, both of these levels become resistance levels. 

This rebound movement does not always occur, but the trading volume may help determine the size of the rebound.

If the initial breaking of the rebound movement occurs during heavy trading activity, the chances of this movement occurring decrease. The increasing trading activity reflects significant pressure in the downward direction. 

However, if trading volume decreases during the initial break, this increases the probability of this movement, and the rebound is associated with low trading volume, while the subsequent direction is associated with high volume.

How to tell if it is Head and Shoulders?

Having explained the working principles of the pattern, we can identify the basic components of the Head and Shoulders:

1. There was a previous uptrend.

2. A left shoulder is with higher trading volume, followed by a corrective decline.

3. A new high level is with lower trading volume.

4. A decline moves below the previous peak and approaches the previous reversal peak.

5. A third upward movement is accompanied by noticeably low trading volume, failing to reach the head peak.

6. The price is closing below the neckline.

7. The price rebounds to the neckline after declining to new levels.

By identifying these components, you can predict a possible trend reversal.

Conclusion

While Head and Shoulders are one of the most reliable reversal patterns, it does not always lead to a reversal in price direction. Sometimes the price may break through the neckline and then continue to rise instead of falling as expected. Confirm the signals of the pattern with other technical indicators and follow the economic news to make well-informed decisions.

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