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How To Trade Head and Shoulders Pattern

What is a Head and Shoulders Pattern

Head and Shoulders is a bearish pattern.

head and shoulders

In a uptrend

1. A stock rallies to a peak on heavier volume and then declines (forming a left shoulder).

2. It then rises again and moves higher than the previous peak but on lighter volume.

3. It declines again and moves below the previous peak (forming a head).

4. The stock then rises a third time on noticeably lighter volume but fails to pass the peak of the head and declines (right shoulder).

5. If the stock goes below the neckline, a head and shoulders pattern is formed. Volume should expand at the initial breaking of the neckline. This is a bearish pattern and indicates that the stock might fall further. (There might also be a return move back to the neckline, but should not exceed it, followed by new lows)

 

What is an Inverse Head and Shoulders Pattern

Inverse Head and Shoulders Pattern (head and shoulders bottom) is a bullish pattern, and it looks exactly the opposite of the head and shoulders pattern.

inverse head and shoulders

 

In a downtrend

1. A stock drops to a bottom and then goes up (left shoulder).

2. It then drops again and moves lower than the previous bottom and goes up again (head).

3. The stock then falls another time but fails to break the previous bottom and bounces back. (right shoulder)

4. If the stock goes above the neckline, an inverse head and shoulders pattern is formed. This is a bullish pattern and the stock might go up further.

 

Slope of Neckline

In a head and shoulders pattern, the neckline usually slants upward or stays horizontal. If the neckline tilts downwards, it signals market weakness and is usually followed by a weak right shoulder.

In an inverse head and shoulders pattern, the neckline slants downward or stays horizontal. If the neckline tilts upwards, it signals market weakness.

 

Volume during a Head and Shoulders Pattern

There is lighter volume on each peak during a head and shoulders pattern. For example, the 2nd peak (head) should have lighter volume than the 1st (left shoulder), indicating that buying is diminishing. The 3rd peak (right shoulder) should have noticeably lighter volume than the previous 2 peaks.

 Volume should expand on the breaking of the neckline, decline during the return move, and expand again when the return move is over and the trend resumes.

Once prices break the neckline, they should not recross the neckline. Otherwise, this would be a failed head and shoulders pattern if prices resume to their original trend.

Let's look at the chart for Dow Jones, does this look like a head and shoulders pattern? Watch out!

head-and-shoulder

In a downtrend

1. A stock drops to a bottom and then goes up (left shoulder).

2. It then drops again and moves lower than the previous bottom and goes up again (head).

3. The stock then falls another time but fails to break the previous bottom and bounces back. (right shoulder)

4. If the stock goes above the neckline, an inverse head and shoulders pattern is formed. This is a bullish pattern and the stock might go up further.