Dissecting The Head And Shoulders

The head and shoulders chart pattern has become a stalwart in the arsenal of many traders over the last few decades. The reason is not difficult to find: it has proven itself to be a remarkably reliable indicator of future price movements.

As the name implies, the pattern looks very similar to a head with two shoulders on the side.

The following graph shows a typical head and shoulders pattern.

Reversal Pattern
The head and shoulders pattern is what is referred to in the industry as a reversal pattern. This simply means that when a CFD trader encounters this pattern on a stock, FX or commodity chart, chances are very good that the underlying security is about to undergo a change in trend.

The pattern has two different versions, one that appears in uptrends and one that appears in downtrends. The traditional pattern pictured above appears when the uptrend is about to be reversed and a downtrend becomes a very high likelihood.

Before The Uptrend
The second version, sometimes described as the inverse head and shoulders, usually appears in a downtrend and this signals that the trend is about to reverse and that a new uptrend has become a high probability.

The graph below shows a typical inverse head and shoulders pattern. Note how the volume increases once the new trend gets properly underway.

Similarities: Peaks And Troughs
The construction of both types of head and shoulders patterns is quite similar. Studying the chart will show a head section in the middle, two shoulders on the sides and two necklines between the shoulders and the head.

What the trader should wait for, here, is the second shoulder to form and the price to break up or down above or below the second shoulder. This happened at point A in both the above charts.

The head and shoulders together form a set of peaks and troughs. On the other hand, the neckline provides a level of support (during and uptrend) or resistance (during a downtrend).

Down's Theory
Essentially the pattern is based on an analysis of peak-and-trough analysis in terms of Down’s Theory. An uptrend can be interpreted as a series of successive rising tops and rising bottoms. Whereas, a downtrend consists of a series of lower highs and lower lows.

When the trend starts to weaken, these ‘peaks and troughs’ fail to make new highs (during an uptrend) or new lows (during a downtrend) -- hence the trademark troughs of the head and shoulders pattern. Note that the two troughs do not always fall on a horizontal line, the second one might be slightly higher or lower than the first one.

Sometimes, immediately after breaking through the ‘neckline’, the price of a security will revert back to the neckline.

The 'Throwback'
At the point marked ‘throwback’ in the above chart, the price had broken through the shoulder and then dropped back to the same level. This is no cause for alarm. All it signifies is that what previously used to be a resistance level has now changed to a support level. It actually underscores the strength of the signal.

If the price, however, drops significantly below the shoulder in what is supposed to be the start of a new uptrend, it could mean the trend has been broken and that the previous downtrend would continue.