The head and shoulders pattern is a technical analysis pattern commonly observed in equity markets. It is formed by three peaks (or highs) and two troughs (or lows) on a price chart. The pattern resembles the outline of a head with two shoulders on either side. The head and shoulders pattern typically indicates a trend reversal from bullish to bearish and is composed of the following key components:
- Left Shoulder: The left shoulder occurs during an uptrend and represents a peak in the price of the asset. After reaching this peak, the price retraces to form a trough, known as the neckline.
- Head: Following the left shoulder, the price experiences a temporary rally, forming a higher peak known as the head. The head is higher than the left shoulder, indicating that buyers are still active, but their strength may be diminishing.
- Right Shoulder: After the head is formed, the price declines again but fails to reach the same level as the head. This forms the right shoulder, which is lower than the head and resembles the left shoulder. The price then rises from the right shoulder but fails to surpass the level of the head.
- Neckline: The neckline is a trendline drawn by connecting the lows of the left shoulder, head, and right shoulder. It acts as a support level for the price. If the price breaks below the neckline, it is considered a confirmation of the pattern and signals a bearish trend reversal.
- Volume: Volume can be an essential indicator in confirming the head and shoulders pattern. Typically, volume is highest during the formation of the head and decreases during the formation of the right shoulder. A significant increase in volume upon the breakout below the neckline adds confirmation to the pattern.
When the price breaks below the neckline after completing the formation of the right shoulder, it suggests that the bullish trend is weakening, and a potential trend reversal to a bearish phase may occur. Traders often use this pattern to identify selling opportunities or to exit long positions.
It’s important to note that like any technical analysis pattern, the head and shoulders pattern is not foolproof and should be used in conjunction with other technical indicators and fundamental analysis for making trading decisions. False signals can occur, so it’s essential to wait for confirmation before taking action based on this pattern.