The "Head-and-Shoulders" pattern is said to be one of the most reliable trend-reversal patterns. Some technical analysts believe that Head and shoulders patterns precede significant declines in at least 8 out of 10 instances. Regardless of the actual statistics, many traders believe the pattern enough to trade it, thereby reinforcing its underlying trend reversal. The psychological impact of the pattern is more than enough reason to gain a clear understanding of the pattern.
There are four basic parts of the head and shoulder pattern. They are the left shoulder, the head, the right shoulder and the neckline. For a head and shoulder pattern to be considered valid a prior uptrend must be in existence.
Practical ExampleToday we will be looking at Wesfarmers (WES) from May 2005 until February 2006. The graph below points out the four main features mentioned above. Below we will be looking at the head and shoulders pattern more closely.
There are several things you must be aware of when identifying a head and shoulders pattern, they are, prior trend, neckline and volume.
Prior Trendline: Notice in the above example that there is a prior trend (red line) in place before the head and shoulders formation. It is important to note that this pattern is a reversal, therefore there must be an existing uptrend.
Neckline: The neckline is clearly highlighted in the above example. Notice that often the neckline becomes a resistence line further down the track (yellow area). It must be mentioned that the neckline doesn't have to be horizontal.
Volume: Many believe that the volume of the left shoulder should be more than the head and the volume of the right shoulder must be less than the head. In the above example notice that the volume of the head is more than right shoulders, however the volume of the left shoulders is less than the head(highlighted in purple), which strictly is incorrect, but close enough. It is also important to have increasing volume on the breakout. That is, once the price falls below the neckline.
Target Price: The target price is the distance between the head($41.70) and neckline ($38.65). This figure ($3.05) is the subtracted from the neckline. The target price was of $35.60 was reached on 28th of October.
The head and shoulders pattern should form over several months. The pattern doesn't have to be exact, but there must be an existing uptrend before the formation because this is a reversal pattern.
It is important to note that there is an inverse head and shoulders pattern, which is basically a reverse mirror image that is predicated on a the existance of a downtrend. This has been covered in a previous "Knowledge Bank" discussion and will be the basis for a future analysis.