Technical Analysis: Head-and-Shoulders Reversal

Introduction

A head-and-shoulders (H&S) formation is a chart pattern that indicates a trend reversal. It can occur at the top of an uptrend (i.e. H&S top) or the bottom of a downtrend (i.e. H&S bottom). It is important for one to keep in mind that a trend reversal must has something to reverse, which means that a real H&S formation comes from a well-established uptrend or downtrend. It is called head-and-shoulders due to the pattern’s resemblance to the head and shoulders of a person.

How to Identify Head and Shoulders

An ideal H&S top formation is consisted of 4 stages:

1. A strong rally which marks the high point of a current trend, followed by a minor recession that completes the left shoulder.
2. Another rally which reaches a higher level than the top of the left shoulder, followed by another downturn that takes the price down to somewhere near the bottom level of the left shoulder. This forms the head.
3. A third rally, which fails to reach the height of the head before another decline sets in. This is the right shoulder.
4. Finally, decline of prices in this third recession down through a line (the “neckline”) drawn across the bottoms of the reactions between the left shoulder and the head and the head and right shoulder, respectively, and a close below that line by a considerable margin. This is the “confirmation” or “breakout”.

The H&S bottom formation is simply the reverse of a H&S top.

Additional features that increase the likelihood of a real H&S formation:

1. Breakout of the neckline is accompanied by relatively greater volume than usual.
2. The tops of the left and right shoulders are approximately the same.
3. Neckline happened to be a historical strong support in the case of a possible H&S top, or resistance in the case of a H&S bottom.
4. H&S formation that occur on daily or even weekly chart. Traditionally, H&S formation is seen as a major reversal pattern. In another word, it reverses the “big” trends.

Example of Identifying H&S formation

Fig.2 shows the emergence of H&S bottom before the price of West Texas Crude Oil reversed from a downtrend to an uptrend in the beginning of 2019. Notice all the essential features of a H&S formation: well-established preceding trend, left shoulder, head, right shoulder and breakout that serves as the confirmation to the completion of this pattern. Traders should be alerted when the right shoulder is formed, and start paying attention to any potential breakouts.

How to Trade H&S Patterns

There are 2 additional rules that a trader should keep in mind when trading H&S formation:

1. It is normal for a pull-back move to ensue following the breakout of the neckline. As long as the pull-back does not carry the closing price above the neckline in the case of a H&S top, or carry the closing price below the neckline in the case of a H&S bottom, the reversal is believed to be still in effect.
2. The minimum probable objective following the breakout – so there’s a breakout, how far will the price move? For a H&S bottom, measure the vertical distance between the bottom of the head and the neckline. Next, measure the same distance up from the neckline at the point where prices finally penetrated it following the completion of the right shoulder.

Continuing with the Crude Oil example, traders should be alerted when the right shoulder is formed and start paying attention to any potential breakouts. In Fig.3, the minimum measured move is identified by the 2 identical intervals, which would have given a target of USD$64 per barrel. Additionally, since a close below the neckline of the H&S bottom renders the reversal invalid, many traders place stop-loss beneath the neckline.