The purpose of this series is to educate newer traders on the basic principles and techniques of technical analysis. To a lot of you, this is old news, but for the rest of you, we are here to help you build a solid foundation for identifying patterns on price charts.
The Head and Shoulders Pattern is historically considered to be one of the most reliable major reversal patterns in technical analysis. In today’s lesson, we will focus on the characteristics of the Head & Shoulders (H&S) Bottom, as well as the minimum price objective after a breakout, and stop-loss levels.
The H&S Bottom is basically a mirror image of the H&S Top, and consists of five key reversal points; three troughs, making up the left shoulder, the head and the right shoulder; and two peaks connected by a trendline, also known as the neckline. The major difference between the two setups is that the volume patterns are much more significant for the H&S Bottom. It takes a great deal more buying pressure to reverse a downtrend than it takes selling pressure to reverse an uptrend.
Identifying a Head & Shoulders Top
First and foremost, in order to be considered a reversal pattern, a H&S top must be preceded by a downtrend. As stated above, volume plays a significant role while this pattern is setting up, but time is also a major factor that should not be overlooked.
As selling pressure begins to drop in a downtrend, the left shoulder will form with a sell-off down to Point 1 being made on high volume, followed by a reversal up to Point 2 on low volume. The head is then formed with another reversal down to Point 3, typically on lighter volume than the break down to Point 1.
Hint: The new low at Point 3 being made on lighter volume than Point 1 should be your first early warning signal of a possible change in trend.
Next is another reversal higher from Point 3, breaking through the resistance line made by Point 1, up to Point 4, on noticeably increased volume. Please note, once both peaks have been established, you can now go ahead and draw the neckline connecting points 2 and 4.
Hint: Violation of the resistance line drawn from Point 1 on increasing volume is your second warning sign of a possible change in trend.
The right shoulder is formed with a reversal from Point 4 to Point 5 on low volume.
Hint: This part is crucial. The failure of price to break below Point 3 after reversing from Point 4 results in a lower high, which is a textbook indicator of an uptrend.
Once price reverses higher from Point 5 on heavily increased volume, it should now be clear that a change in trend is occurring.
Confirmation of the pattern is made when a price bar closes above the neckline on extreme volume. Because of the number of objectives that need to be met in order to confirm this pattern, it is advised to not initiate a long position until confirmation has been made.
How to Trade a Head & Shoulders Top
The measured move for a H&S top is the distance between Point 3 and the neckline, measured upward from the breakout price. For example, let’s say the low price at Point 3 is $90, and the price at the neckline measured straight up from the high is $120, your measuring objective now becomes $30. So, if the breakout price is also $120, your first price target would be a measured move of $30 lower, or $150.
Historically, there is a greater chance of a retest of the neckline after a bullish. The retest should be made on lower volume, followed by another sharp increase in volume as price continues higher.
Stop levels for the H&S Bottom are the same as for the H&S Top. The first, and most conservative, is just below the newly formed up trendline. It is believed by some that the breach of a major trendline is a precursor to a trend reversal, and any long positions should be covered once the new trendline is violated.
The second level, and most common, is the neckline, because this would indicate the failure of new support levels to hold. Lastly, and the most extreme stop level, is a breach of the initial down trendline. If price gets back to this level, it usually means another trend reversal has occurred, and new lows are being made.
- Price, volume and time are all key components to the reliability of a H&S reversal pattern, with volume having more weight than it does in the topping formation.
- 5 key reversal points make up this pattern.
- All objectives need to be met to confirm a breakout.
- 3 common stop levels will help you adjust your risk parameters.
More Topstep Trading 101 Lessons: