One of the most popular technical patterns is the head and shoulders pattern. The head and shoulders pattern indicates an uptrend’s reversal and is a reliable pattern with a high success rate. Does it mean that it will work every time? No, does any indicator or pattern work 100% of the time? I trade trends and the head and shoulders pattern is not a pattern I choose to trade against, as the pattern tends to be correct more times than not once confirmed. What is a head and shoulders pattern and how do you trade it?

Head And Shoulders Pattern

A head and shoulders pattern is one type of reversal pattern that indicates an end to an uptrend and a beginning to a new downtrend. Look at the picture below (current S&P 500 chart with a head and shoulders pattern) before I explain a head and shoulders pattern and how to calculate where, based on the pattern, the market, stock, or futures, etc. is going.

Head And Shoulders Pattern Explained

The left shoulders forms in a natural uptrend as the stock makes new highs then falls back (or corrects to what will be called the neckline, this will be the first point of the neckline) before pushing higher to make new highs (head).

After making new highs, the security then falls back from the head to previous lows where it finds resistance. This resistance is from the prior pull back.

The security will start to push higher, and will be unable to make new highs. It is as this time you will notice the formation coming into play. This upward push is the beginning of the right should and is unable to get through the highs created in the left shoulder. It is at this time that you need to connect the two pullback points to create the neckline.

Confirmation of the pattern comes when the security passes through and holds the neckline. Traders will start getting into short positions at this time. As you can see from the chart above, the S&P 500 has not yet broke the neckline. The upcoming week will be an important week as to whether the uptrend is over.

How To Calculate The Potential Move

In an equation, it looks like the follow:

Neckline – (High Point in Head – Neckline) = Price Target

Using the image below (DOW Head and Shoulders Patter), take the high point of the head which is roughly 8,800 and the neckline which is about 8,200. In short, you can expect to see a 600-point move to the downside.

8,200 – (8,800 – 8,200) = Price Target

This gives a price target of 7,600 on the DOW. I recommend that you get out before taking out the target unless the markets or a security (whichever you are trading) is falling apart.

Things To Keep In Mind

• The volume is normally highest in the left shoulder. As the stock reaches new highs (in the head), it is usually not supported by volume.
• The neckline does not have to be perfectly horizontal, it can slightly move up or down.
• Shoulders should peak around the same price.
• You do not have to get short positions but should at least lighten up your holding(s) and buy them at cheaper levels.
• Head and shoulders patterns can be used with all types of securities, whether an individual stock or index futures.