The Head and Shoulders chart pattern is a heavily used charting pattern, giving easily understood potential buy and sell signals.
The chart of Home Depot (HD) below shows a Head and Shoulders pattern:
Head and Shoulder Components
- Left Shoulder: Bulls push prices upwards making new highs; however these new highs are short lived and prices retreat.
- Head: Prices don’t retreat for long because bulls make another run, this time succeeding and surpassing the previous high; a bullish sign. Prices retreat again, only to find support yet again.
- Right Shoulder: The bulls push higher again, but this time fail to make a higher high. This is very bearish, because bears did not allow the bulls to make a new higher or even an equal high. The bears push prices back to support (Confirmation line); this is a pivotal moment – Will bulls make another push higher or have the bears succeeded in stopping the move higher.
Head and Shoulders Potential Sell Signal
If prices break the confirmation support line, it is clear that the bears are in charge; thus, when price closes below the confirmation line, a potential sell signal is given.
Note that a downward sloping confirmation line is generally seen as a more powerful Head & Shoulders pattern, mainly because a downward sloping confirmation line means that prices are making lower lows.
The opposite of the Head & Shoulders pattern is the Reverse Head & Shoulders pattern which is another strong pattern, this time a bottoming pattern.
Reverse Head and Shoulders Components
The reasoning behind a Head & Shoulders pattern is as follows:
- Left Shoulder: Bears push prices downwards making new lows; however, bulls begin to return and push prices slightly higher.
- Head: Price gains don’t last long before bears return and push prices even lower than before; a bearish sign. Prices then find buyers at the new lower prices.
- Right Shoulder: The bears push downward again, but this time fail to make a lower low. This is generally seen as bullish sign, bears were unable to push prices further down. Decision time occurs when the price is pushed higher back to support (Confirmation line); either bears will push prices back down or bulls will push prices higher, regaining control of the stock, future, or currency pair.
Reverse Head and Shoulders Potential Buy Signal
When price closes above the confirmation line, a potential signal is given.
Usually an upward sloping confirmation line is seen as a more powerful Reverse Head & Shoulders pattern, mainly because an upward sloping confirmation line means that prices are making higher highs.
Volume analysis is important when using the Head & Shoulders chart pattern. How to incorporate volume into the study of the Head & Shoulders pattern is discussed next.
Volume and Head and Shoulders
When the confirmation line of a Head & Shoulders pattern breaks to the downside, a large amount of volume should occur as well.
The chart below of General Electric (GE) shows a sharp increase in volume when the confirmation line of the Head & Shoulders pattern was broken:
In addition to the sharp increase in volume, the gap down on the chart of GE also gave strong indication to potentially sell when the confirmation line was pierced.
The same concept applies to a Reverse Head & Shoulders pattern, the break of the confirmation line should be accompanied by an increase in volume.
The chart below of Gold futures illustrates a rise in volume when the confirmation line was pierced:
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