Trading Head &
Shoulders Patterns
above neckline for a breakout signifies completion of the
pattern.
Success/Failure Ratios: Head and Shoulders (SF Ratio: 0.59)
have lower success/failure ratio than Head and Shoulders
pattern (0.682).
by Suri Duddella
One of the most popular chart patterns in market analysis is
"Head and Shoulders" (H&S) pattern. The H&S patterns form
near market tops in an established sideways to up trending or
bullish markets. The H&S patterns are reversal patterns as
they reverse its prior uptrend and follow a bearish or
downtrend from its breakdown. These patterns are signified
by three successive peaks (tops) resembling two shoulders on
both sides and a head in the middle. The head is the largest
of the three peaks.
H&S Pattern Components
Head & Shoulders: The 'head' and 'shoulders' in H&S
patterns are formed by three successive peaks (tops). The
middle peak (head) is the largest in the pattern. The ratio of
the height of the head to the largest of shoulders height and
should be less than 0.78. The size of the head is measured as
the vertical distance from the neckline to the peak of the
head.
Neckline: The neckline is formed by connecting the lows of
shoulders and the lows of the head in the H&S pattern. These
reaction lows are formed to define the pattern structure. The
neckline can be up, down or horizontal sloped line. Upward
slope neckline H&S patterns tend to be more bearish than
downward slopes H&S patterns. In my experience, the
patterns with horizontal necklines produce better results.
Volume: Volume plays a significant role in pattern structure
and its validity of trading rules. Price breakouts from neckline
must be supported by expanded volume for a valid short
entry. Volume build up in the left shoulder is usually higher
than the volume in right-shoulder. During the head formation
(bottom), the volume in the first half of the head may be
higher than volume in the second-half. An increased volume
Trading Head & Shoulders Pattern
Entry: After right-shoulder formation and pattern completion,
if price closes below the neckline with increased volume,
enter a short trade below the breakout bar's low.
Stops: 1. Place a stop above the middle of the neckline and
right-shoulder 2. Place a final stop above the high of the
right-shoulder.
Targets: Targets are projected from the neckline level.
Measure the height of the head and use Fibonacci ratios to
compute targets. The first target range is 62-79% of the
height of the head and second target range is 127-162%
below the neckline.
Examples
The following graphic shows emerging Head & Shoulders
patterns (as of May 22, 2017) in some of the key financial
stocks and ETFs. Most of these Head & Shoulders patterns
are trading near the neckline and needs to close below for
clear pattern confirmation. For example, the H&S pattern in
XLF is trading above neckline 22.89. A close below its
neckline with increased volume would confirm a short trade.
After a successful breakdown below the neckline, XLF H&S
first target range would be $21 to $21.40 and stop is set
above the neckline. Similarly, in JPM stock, H&S neckline is at