A head and shoulders pattern is characterized by three peaks before starting to trend downward.
Canva
What Is a Head and Shoulders Pattern?
A head and shoulders pattern is a chart formation used in technical analysis to indicate a security’s reversal in the direction of price. The technical indicator is based on historical pricing, and investors and analysts often use the pattern to determine primarily whether a downward trend is likely to take place. The chart is most commonly used on stocks, but is also popular on foreign exchange, commodities, and cryptocurrency.
A typical head and shoulders pattern is characterized by an initial rally to a peak (the first shoulder) followed by a short decline, which is then followed by another rally to a higher peak (the head), after which the stock falls again briefly before rallying to a third peak at about the same level as the first (the second shoulder). This third peak (and second shoulder) theoretically indicates the beginning of a bearish breakdown, or a longer period of decline in an asset’s price.
During times of volatility, and sometimes in the absence of news that might affect a company’s stock price, some investors and analysts turn to technical analysis and indicators such as the head and shoulders pattern to analyze price movements.
What Is an Example of a Head and Shoulders Pattern?
In this candlestick graph (which shows daily intraday highs and lows, and closing and opening prices) pictured below, Apple’s stock price movement from late 2021 to early 2022 highlights the heads and shoulders pattern. In the first shoulder, from early to mid-December, the stock rallies until it reaches a peak, and the price subsequently declines. It reaches a low before rallying again toward late December and making a new high to form a peak, or head, in early January. The stock then declines before reaching a new low. The subsequent rally peaks and forms the second shoulder.
When the stock’s decline breaks through the same price level set at the end of the first shoulder and at the start of the second shoulder, the sentiment turns bearish. The level at those troughs is known as the neckline, and the stock’s downward slope is known as the breakdown. In Apple’s case, the breakdown reaches price levels not seen since November. The stock held steady before it rallied following the release of strong quarterly earnings and record revenue.
Ideally, the peaks of the first and second shoulders would be at the same price levels, but this is not always the case.
Apple’s head and shoulders pattern started to form in early December, and its price dropped around January to levels not seen in about two months.
TheStreet
What Is an Inverse Head and Shoulders Pattern?
An inverted head and shoulders pattern is known as an inverse head and shoulders, or head and shoulders bottom. Just as its name implies, the pattern is the opposite of head and shoulders, where the peaks become the troughs, and it is used to determine whether sentiment will turn bullish. A rally’s slope after the second inverted shoulder is known as the breakout.
What Are the Limitations of a Head and Shoulders Pattern?
The head and shoulders pattern can be used in conjunction with other technical indicators and momentum oscillators such as the relative strength index and moving average. However, it’s often viewed as a short-term trading strategy, and it’s difficult to predict when a stock will reverse its trend from a breakdown.
What Is the Typical Length of a Head and Shoulders Pattern?
Length depends on the trading activity of a stock. Small, daily price changes and little trading volume could result in a months-long pattern. Heavy trading and large daily price changes could create a pattern in a matter of weeks.
