Methodology

Stocks

Module 4

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Head & Shoulders

Head & Shoulders

Another well-known technical indicator is called the ‘head & shoulders’. It has been given that name as the pattern is similar to a head and shoulders – as you can see above. 

 

When a head & shoulders pattern forms, it is believed that this means that the trend will reverse. So, if the price of a stock was going up before the head & shoulders pattern formed, it is believed that it will go down following it.

 

For a head & shoulders pattern to be valid, each peak should return to exactly the same level as the previous peaks. The exception to this would be the very last peak, as it would continue down, following a negative trend.

 

As you can see, the middle spike should also be taller than the other two, with the left and right peak reaching similar levels. It is common for a false head & shoulders pattern to form, which usually happens when one of the peaks fails to return to the original level set by previous peaks.

Inverse head & shoulders

The opposite is called of a head & shoulders is called an ‘inverse head & shoulders’. It is basically the same concept but upside down.

 

If the price of a stock was going down before the inverse pattern forms, it suggests that it will go up when it is fully formed.  As before, for an inverse head & shoulders pattern to be valid, all three peaks should return to the same level (indicated by the dotted line). Of course, the exception would be the final peak, which would go on to follow a positive trend.

 

As with a standard head & shoulders, the middle peak should be longer than the other peaks. In theory, if a trader invests money as the inverse head & shoulders pattern forms, they may benefit from a large gain – as long as it is a valid head & shoulders pattern.

 

Likewise, if a trader sells their investment as a standard head & shoulders pattern forms, it may save them from losing a significant amount of money when the market falls.

How effective are head and shoulders patterns?

You may be wondering at this point how useful head and shoulders patterns are. They are mostly used by day traders or swing traders, as those strategies depend on stock chart information. Therefore, this type of technical pattern would not necessarily be useful for long term investors.

 

Trading with head and shoulders patterns is not an exact science and it can often be challenging. Timing is a big problem with this type of pattern as a trader may think that it has formed, only for one peak to drop below the level set by previous peaks – this particularly can happen with the middle peak. If traders jump in too early, it can be the case that the head & shoulders pattern is invalid and not useful. This has the potential to incur losses for traders.

 

In terms of the effectiveness of the pattern, head and shoulders patterns are thought to be one of the most reliable technical indicators. With that said, the randomness of the stock market at times means that it will not always be correct. Therefore, it may be the case that it is useful only some of the time.

When a head & shoulders pattern forms, what is believed will happen?

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