Lesson 2 of 5
In the Chart Patterns Overview, we discussed that reversal chart patterns signal the ending on an ongoing trend, i.e., they signify a reversal of asset’s price direction. Head and Shoulders is the most common reversal pattern. There can be a normal head and shoulders pattern or inverse head and shoulders pattern, depending on whether the price trend before the formation is an uptrend or a downtrend.
Head and Shoulders
A head and shoulder pattern is preceded by an uptrend in the asset’s price. When the head and shoulders formation is seen, it signifies that the prices will now start moving downwards. The formation is depicted below. You will notice that there is a left shoulder, a head followed by a right shoulder.
The graph is read in conjunction with the volume of trade. The left shoulder is formed at the end of an extensive uptrend. The slope of the left shoulder uptrend is more than the one in the normal uptrend prevalent prior to it. This is followed by selling and the price falls down to its previous level. The left shoulder exhibits significantly high volumes. The rally begins again and the head is formed. This time the volume is high or normal. Followed by the head, the right shoulder is formed similar to the left shoulder but with significantly less volume. Once the price crosses below the neckline, it signifies the end of the head and shoulder formation.
The head and shoulder formation will rarely be perfect. However, the general characteristics will remain the same. The head will rise above both the shoulders, and the two shoulders will be very similar. The right shoulder will have significantly less trading volume, than the left one.
Once the formation is identified, it signifies that the price trend will reverse, and the prices will start moving downwards below the neckline. The trader should take advantage by placing a short order below the neckline.
Inverse Head and Shoulders
The inverse head and shoulders pattern is exactly the opposite of the normal head and shoulders pattern. It is preceded by a downtrend in the asset’s price, and the formation signifies that there will be a price uptrend after the formation. The inverse formation is depicted below:
Once the formation is identified, it signifies that the price trend will reverse, and the prices will start moving upwards and will cross above the neckline. The trader should take advantage by placing a long order above the neckline.