In this installment of our technical patterns education series, we will explore what is known as a "Head and Shoulders" pattern. This pattern can signal a shift in trend whether at the top of a price discovery trend or at the bottom (when it is referred to as an "inverse head and shoulders bottom" pattern).
As the name suggests, a head and shoulder pattern comprises of left shoulder that corrects only to move higher to form the "head" typically the highest price point in the prevailing price trend (or the lowest price point in the case of an "inverted head and shoulder bottom pattern" after which it will correct while only to rally again but not as high as the previous "head". This point marks a trend reversal, down in the case of a traditional head and shoulder pattern and up in the case of an inverted head and shoulders bottom pattern.
The chart to the left provides a classic example of a head and shoulders pattern whereas the chart below of Cisco in 2000-2001 shows how these can play out in real markets.
It is not always easy to idenitfy head and shoulders patterns. Sometimes they do not play out in exactly the traditional text book way. These pattern can also play out or seem to be playing out in the midst of any rising or declining trend when the actual top or bottom of the market has yet to occurr. As a result your entry or exit points can be erroneous.
As we mention in all these educational pieces it is best to use technical analysis in concert with multiple signals to increase your probability of being right in your determination of a market. Timing market cycles is hard which means in addition to your forecasting methodology, you need to have expert asset allocation and stop loss disciplines in place to manage the inevitable wins and losses no matter what timeframe you are investing or trading in.