The head and shoulders pattern
Three highs, the middle one highest, with a neckline below. When the price falls below it, the previous uptrend counts as over. It's also one of the patterns most often misread.
The head and shoulders is probably the best known chart pattern. It appears after a rise and counts as a sign that the trend is turning. The shape looks like a silhouette: a shoulder, a higher head, a second shoulder.
What it's about
The price rises to a high, falls back, rises to an even higher high, falls again and afterwards only manages a lower high. Buyers are losing strength. As long as the price stays above the neckline, though, the pattern is just a possibility, not a fact.
How to recognise it
- There was a clear rise beforehand.
- Three highs, the middle one clearly the highest.
- The two lows in between can be connected by a line, the neckline.
- Only a close below the neckline completes the pattern.
How the price target is estimated
The usual rule of thumb: measure the distance from the head to the neckline and subtract it from the breakout point. With a head at €62 and a neckline at €52, that's €10. The estimated target is €42. It's a rough guide, not a promise.
Where it misleads you
Many people see the pattern before it's complete. A right shoulder only exists once the price actually falls afterwards. And even after the neckline breaks, the price often comes back. As analyses such as Thomas Bulkowski's show, a considerable share of patterns never reach their target.
The neckline is also often sloped, and where exactly it sits is something you decide yourself when drawing it.
An example trade with made up numbers
A year ago Rolf bought 100 shares at €40. The stock is at €58, and a head and shoulders pattern is forming with the neckline at €55. Many people don't use a falling pattern for short selling but as a reason to sell or protect an existing position. So does Rolf.
The decision: Rolf decides in advance: if the stock closes below €55, he sells. That happens and he sells at €54.50. After a €1 fee and a little spread, Rolf locks in about €1,447 in profit.
If the pattern holds: The stock falls to €48. Compared with holding on, Rolf avoided a €650 drop in value.
If it was a false breakout: The stock turns and rises to €63. Rolf misses out on €850. He can buy back in, but at a higher price.
Both outcomes are possible. What makes the difference is that Rolf set his rule in advance instead of deciding in the heat of the moment.
Richard Schabacker described the formation as early as the 1930s, and Edwards and Magee later made it famous in “Technical Analysis of Stock Trends”. Many textbooks stress that volume at the right shoulder is usually lower than at the head.
After the break, the price often returns to the neckline from below, the so called pullback. Some wait for this test before acting. That lowers the risk of a false signal but costs part of the move.
Academic studies with automatically detected formations, such as Lo, Mamaysky and Wang in 2000, find at most weak effects that usually disappear after trading costs.
Summary
- The head and shoulders is only complete with a close below the neckline.
- The price target is a rough rule of thumb.
- False breakouts are common, so the rule belongs before the decision.
Did you get it?
When is a head and shoulders pattern complete?
Only when the price closes below the neckline.
Head at €62, neckline at €52. Where is the estimated target?
At €42, the €10 head height below the neckline.
Why is the neckline an uncertain point?
Because you draw it yourself and it's often sloped.
Sources and further reading
- StockCharts ChartSchool, Head and Shoulders Top. View source ↗
- Thomas N. Bulkowski: Encyclopedia of Chart Patterns, 3rd edition 2021.
Related
- Inverse head and shouldersChart pattern
- Double topChart pattern
- What chart patterns can doLesson