What are Head and Shoulders mean?
The head and shoulders pattern is one graph pattern that can be relied upon in technical analysis. And as you can imagine from its name, this pattern is in the form of a head with two shoulders.
Head and shoulders are reversal patterns that, when formed, indicate that prices will move in contrast to previously formed trends. There are two main forms of this head and shoulders pattern.
Top head and shoulders is a technical signal that the price is ready to move down, when the pattern is complete and confirmed, and is usually formed at the highest price of an uptrend.
The second form is a bottom head and shoulders (or commonly known as inverse head and shoulder because of its reversed shape), which indicates that prices are ready to move up and are usually formed when a downtrend occurs.
The two forms of head and shoulders have the same construction in which there are four main parts.
The section is two shoulders, one head and a confirmation line called the neckline. This pattern is confirmed if the neckline is successfully crossed, after the formation of the second shoulders.
What Happen After a Head and Shoulders Pattern?
Head and shoulders are a collection of peaks and troughs.
Peaks are conditions in which prices reach their peak and have a tendency to correction, while troughs are conditions where prices are in transition after correction and are ready to rise again.
Neckline will be a support and resistance level.
This pattern is based on the analysis of the peak-and-trough of Dow Theory.
For example, an uptrend is seen as a period where peaks and troughs increase repeatedly.
For the downward trend the reverse, where the peak and trough decreases. The head and shoulders pattern illustrates the weakening of a trend where there are weakening conditions on peaks and troughs.
How to Trade Head and Shoulders Pattern?
How to trade with the head and shoulders pattern, we first need to know what conditions to determine the head and shoulders pattern is formed
Requirements for the establishment of a head and shoulders pattern
All right, all the conditions below must be fulfilled and can only be said as Head & Shoulder Pattern:
The bullish trend that has been formed. The stronger the trend the better!
Large volume on the Peak of the Left Shoulder (point A) followed by a decrease in Volume at the Base of the Left Shoulder (point B)
Rally to a point higher than the peak of the left shoulder but the volume is relatively small (Point C)
Sharp correction or decrease near the base of the left shoulder (point D)
Rally again to approach the top of the left shoulder (point E) but not followed by a significant increase in volume
Closing below the neckline line is followed by a relatively large volume
Usually, there is a small rally that touches the neckline line then the price moves to the bear!
Head and Shoulders Pattern Formation Process
This pattern is a reversal pattern, if there is an uptrend, the price will likely make a downward movement if this formation is formed completely.
Vice versa, if there is a downward trend, the price will have a tendency to move up. In the formation of this pattern, both top and bottom head and shoulders, there are four steps so that this pattern is truly complete in the formation process.
Top Head and Shoulder
The first step in forming this pattern is the left shoulder, which is formed when the price reaches a new high and then moves to a new low.
The second step is the formation of a head formation, which occurs when the price breaks the previous high (left shoulder), then returns correction to or near the lowest price formed on the left shoulder.
The third step is the formation of the right shoulder, which is formed when the price moves up again but does not succeed higher than the highest price on the head which is then followed by a decline in prices towards the lowest price on the left shoulder. This pattern is completely formed and confirmed if the price succeeds in passing the neckline, which is the support created in the formation of the lowest price of the left shoulder and head.
Inverse Head and Shoulders (Bottom Head and Shoulders)
The formation process is the same, but the formation is reversed.
Beginning with the formation of the left shoulder, which occurs when the price drops to a new low then rebound to a higher price.
The formation of the head, which is the second step, occurs when the price succeeds in forming a new lowest price versus the lowest price of the left shoulder, followed by a rebound of the price to or near the highest price level on the left shoulder. The movement to the highest on this left shoulder forms the neckline for this pattern.
The third step is the formation of the right shoulder formation, where a sell-off pushes the price down, but fails to break the lowest price on the head, which is then followed by a return to the neckline. This pattern is complete and confirmed if the price manages to move past and higher than the neckline.
Break of the Neckline and its Reversal Potential
This head and shoulder pattern will be completely formed if the price manages to cross the neckline line, then the trend is considered reversing, and the price will likely move in a new direction.
But the price does not always move directly to the new direction after successfully passing the neckline.
For this reason, it is important to be aware of a 'throwback'. A throwback situation is when the price crosses the neckline, making new highs or lows (depending on the pattern formed), followed by a price reversal towards the neckline.
A return to the neckline line is considered a test of the head and shoulders pattern and the creation of new support and resistance.
Keep in mind that when the trend changes (or a reversal pattern is confirmed), what used to be supported then changes to resistance, and the opposite.
Indeed, this movement will make anxious because the price may reverse again and the head and shoulders formation cannot be maintained, but it is not that bad.
If the retest of the neckline line fails, and the price then moves away from the line, this will further strengthen the head and shoulders pattern and the potential reversal will be greater.
We can wait first to try again this neckline line or immediately anticipate it once the complete head and shoulders formation is formed.
The Relationship Between Volume and the Head And Shoulders Pattern
Volume is the number of transactions that occur at that time? How is the calculation of the volume if there are 400 buys and 300 sells? 700 volumes or 100 volumes (400-300)? The truth is 700, regardless of what transactions have occurred in the market.
In technical analysis and price pattern analysis, volume plays an important role as a secondary indicator.
Volume indicates movement activity. When the volume is high, there are many transaction activities that make it a pretty important indicator to follow.
For head and shoulder patterns, the volume is used first when there is a neckline break.
At this point, it becomes important if the neckline line breaks are followed by large volume movements.
Large volume when it manages to break the neckline of the top head and shoulders indicates a large selloff.
Likewise vice versa on the bottom head and shoulders, large volumes when the neckline breaks indicate a large buying activity. The interaction between volume and price movements in forming a reversal signal is not something standard.
However, this is a general trend in chart patterns.
Neckline Slope Line
Another key factor in the head and shoulders pattern is the shape of the neckline line.
The reason is that the neckline line functions as support or resistance during the formation of a head and shoulders pattern, and also becomes the entry point when the head and shoulders pattern is confirmed.
The shape of the neckline line is not only flat but can also have a certain slope. Even in many instances, this neckline line will tilt slightly up or down.
In general, technically strong top head and shoulders as much as possible have a neckline line that is flat or slightly upward.
For the bottom head and shoulders, as much as possible a little downward
An important factor in the technical analysis, but often underestimated, is the calculation of price targets.
This measures the approximate purpose of the next price movement, based on confirmed patterns.
The direction of price movements is assumed to be known, based on the confirmation indication that appears, what needs to be calculated is the possibility of price movements.
This is done so that the target can be determined, both in conditions of profit and loss.
The price target is measured based on the height of the head and shoulders pattern, which is the distance between the top of the head and the neckline line.
As an illustration, suppose the highest price on the head is 1000 and the neckline line is at 900, from here there is a difference of 100.
The price target is calculated by reducing the value on the neckline line (900) with the difference between the head's highest price and the neckline line (100).
From this example, the target price is 800 (900-100). The numbers generated from this calculation are not absolute but as a guide in measuring price targets.