Table of Contents
- 1 Head And Shoulders Formation
- 2 What Is the Head and Shoulders Pattern?
- 3 How the Head and Shoulders Pattern Occurs
- 4 How the Head and Shoulders Pattern Works
- 5 What Is a Reverse Head and Shoulders Pattern?
- 6 How to Identify and Use Head and Shoulders Technical Indicators
- 7 Key Tips on Head and Shoulders Pattern Use
- 8 The Bottom Line
Head And Shoulders Formation
The head and shoulders pattern is one of the most reliable trading indicators you can find.
Wall Street and day traders have used it for decades to inflate their bank accounts.
Here’s why it works …
Think like a new trader (maybe you are one) and look at stock charts. If you don’t know what you’re looking at, you see a bewildering picture.
Then you learn what all those points and candlesticks mean … but maybe you still forget that what you’re seeing is just a map.
And you have to remember that behind the map is a slew of traders and investors sitting at their computers — just like you — and they all have different opinions on the company you’re trading. Some are bullish on it, some bearish.
Money flows into the stock. And money flows out.
If you’ve ever studied military history, a stock chart is like a map of a battle. It’s a picture showing the war between the stock’s bullish and bearish sentiments.
Once you understand that, you can scoop buckets and barrels of cash out of the market.
There are lots of traders who are just like you. They don’t care about the companies — they just want to make money.
Here’s where you come out on top: You can use chart patterns to figure out how other traders feel about a stock and which way the battle will go next.
What Is the Head and Shoulders Pattern?
Pay attention! Here’s the most valuable thing you need to know about the head and shoulders pattern:
It’s a bullish-to-bearish reversal pattern.
The bulls don’t give up right away, though. They keep fighting, even though they run into more resistance than they expect.
The struggle for bullish sentiment to overcome the resistance results in three visible peaks …
The second price peak is higher than the first and the third peaks — that’s the head.
The first and third price peaks are usually at close to the same height — those are the shoulders.
When you see the last price slide break through the support area, that’s a clear sign the bullish sentiment is dead for now, and you should sell the stock short.
Importance of Relying on Predictable Patterns
Too many penny stock traders play the markets like they’re in a casino. They put their orders in blindly, like desperate gamblers throwing down chips.
This is — to be blunt — stupid as hell.
Sure, you can win a few ‘bets,’ but sooner or later you’ll go broke just like every other fool endlessly feeding quarters into a slot machine.
The only casino gamblers who can win in the long run are blackjack card counters and poker players.
They can win because they use their brains to put the odds on their side.
That’s exactly what you need to do, and why you’ve got to trade using chart patterns. Time and the trading experience of countless traders prove they’re usually accurate.
Chart patterns are why experienced traders and hedge fund managers eat the lunches of ignorant traders …
They don’t pick stocks at random. They have a reason for every trade they put on. They look to a predictable chart pattern or other trading indicator for a signal.
And, true: Nothing is 100% reliable. But so what?
If a pattern works 75% of the time, you’ll win 75% of your trades. That’s more than enough to accumulate all the money you’ll ever be able to spend.
In poker, there’s an old saying: If you look around the table and can’t find the sucker, it’s you.
In trading, if you don’t know the patterns and indicators the other traders are using, it’s your brokerage funds the others will suck up, like a vacuum on steroids.
How the Head and Shoulders Pattern Occurs
When you spot a head and shoulders, it means the bull market is dead. It’s time to sell the stock short because the new price trend is down.
Here’s the pattern, from start to finish:
#1 The Left Shoulder
In short: An asset rides the bull to a relative peak, before falling to form a trough.
Here, the stock’s price has been rising on a preexisting uptrend. When the bulls run into resistance too strong to overcome, you see a peak.
The bulls had to beat a strategic retreat. The price falls. You see a retracement.
The picture formed by this — the rise, peak, and fall in price — forms the pattern’s left shoulder.
#2 The Head
The price reaches a bottom. It begins an upward motion again, peaking at a crest higher than the security’s previous one. But it then falls again right afterward.
Here’s a detailed view of what’s happening …
The bullish sentiment is down but not out.
The bulls rally. Now that they know about the resistance, the bulls push extra hard, like a car stuck in snow and spinning its wheels.
The price surges upward again, peaking higher than the left shoulder …
But the resistance is even stronger. So this effort also fizzles out, and the stock’s price slides again.
This forms the head of the pattern. It’s the peak of the bullish trendline.
Typically, the price breaks through the overall trendline when it retraces from the peak or head. This is your cue that a possible head and shoulders is forming.
#3 The Right Shoulder
In its final act, the price rises to the level of the first peak, before it declines again for a final time.
Let’s break that down:
The bullish sentiment is now nearly exhausted, but they give it one last try. The price rises, but the bulls are too weak. They attack the overall trendline, but can’t break through it.
The right shoulder is formed by this retest of the trendline.
The bulls used up their strength forming the head of the pattern, so the price goes up to about level with the left shoulder — or lower — then falls back again.
It’s important that this attempt to keep moving up peaks below the head. If it goes above the head, it’s a higher high. That’s a sign of continuing bullish strength.
With the failure of the right shoulder to break out to new highs, the bears have won the battle for now. The stock keeps sliding, breaking through the support level — it’s a breakdown.
Most importantly, the head and shoulders pattern is a signal to sell the stock.
That’s why it’s wrong to think of chart patterns as just random pictures. Chart patterns are maps of the battles between bulls and bears. That’s what makes them predictable …
How the Head and Shoulders Pattern Works
The head and shoulders pattern marks the end of a bull market. It indicates the stock price is about to fall and the time for you to sell the stock short.
Before you see the full head and shoulders, you may suspect the stock has reached the end of its price rise— but you don’t know for sure.
You don’t want to risk your money without confirmation that the bullish trend is about to reverse.
By itself, the left shoulder is just a retracement. Of course, no stock goes up every single day.
The next leg up forms the head. That still looks like part of a bullish trend, because it’s a higher high.
But the retracement goes back to the same level as the first trough. If this second trough is at the same price or lower than the first trough, that’s a good sign the bullish momentum is failing, because it’s failed to reach a higher low, as trending stocks should.
The line defined by the low points of the two troughs is called the neckline.
After another price push, the stock forms the second shoulder.
But the bullish momentum runs out, so it retraces. When it crosses the neckline and continues to plunge, the head and shoulders chart pattern is complete.
That’s your confirmation! The stock is headed down. It’s time to sell it short.
What Is a Reverse Head and Shoulders Pattern?
This is simply the inverse head and shoulders — or the head and shoulders turned upside down. Everything is the same, but it looks more like a deep gorge with a shallow gorge on each side, instead of a head and shoulders.
This pattern also maps the struggle between bearish and bullish sentiment.
However, in this case, the stock has been in an extended bearish trend.
The bears have dominated, but the bulls begin to push back. That drives the stock up to form the first shallow gorge. The peak forms the first point determining the neckline.
The bears aren’t dead yet, however. They drive the price back down to form a deeper gorge. Then they lose control, and the price rises back, forming a second point in the neckline.
Then the price plunges again, but only about as for as the first gorge (or shoulder) in the pattern.
The bulls regain control and drive the price higher.
When it crosses the neckline, that completes the reverse head and shoulders pattern.
Is a Reverse Head and Shoulders Bullish?
Yes. The stock can’t complete the reverse head and shoulders pattern until the price has crossed the neckline.
That’s the breakout. This confirms it’s now in a bullish trend.
It’s time to buy.
How to Identify and Use Head and Shoulders Technical Indicators
Aside from the head and shoulders pattern itself, the primary technical indicator is the neckline formed by the points of the two troughs.
When the price crosses the neckline, that’s your signal to sell the stock short to take advantage of the coming bear market.
Use caution! When you spot a head and shoulders forming, keep an eye on it. But wait for the price to cross the neckline to confirm a true breakout or breakdown.
Head and Shoulders Pattern Breakout
The breakout comes after the price forms the right shoulder: It moves up, tests the overall trend, but fails to break through it. Usually this is right at the same price as the left shoulder or below it.
The stock is now failing to make a higher high.
The two troughs — the bottoms of the left and right shoulders — define a straight line that’s horizontal or slightly slanted (reminder: that’s the neckline).
When the price crosses the neckline while retracing down from the peak of the right shoulder, that breakout confirms the end of the bull market. (Or bear market in the case of the reverse head and shoulders.)
To really understand this, remember all those traders sitting at their computers I mentioned before …
Lots of traders bought the stock on its way up the bullish trendline. Many of them have now turned bearish or simply want to realize their profits.
So they start to sell. Lots of selling puts downward pressure on the price.
If a lot of traders still believed the price would keep going higher, they would keep buying and drive the price higher.
But when the traders who are selling outnumber the bulls who want to make more profits, the price must go down.
The peak of a bull market is reached when there’s nobody left to buy.
But you can’t know for certain that’s what happened until you see the price break through by crossing the neckline. That’s when to sell short.
With the reverse head and shoulders, the bears have given up. The short sellers are tired of being squeezed, so they go into the market and buy shares to close out their positions.
All that selling drives the price up. Once it breaks out by crossing the neckline, the trend reversal has been confirmed. Buy.
Support and Resistance Lines
Support and resistance lines are price levels where the mass of traders will not allow a stock’s price to cross.
A support level is a minimum price for a stock.
For example: The market believes a company’s stock is worth at least $100. As soon as the price begins to go down close to $100, enough traders step in to buy the stock that its price never breaks below $100.
It might hit $100.50 — but not $99.50.
A resistance level is a price at which the market believes there’s no way a company’s stock is worth that much.
Another example: The market believes a stock is not worth over $200. So, the company’s stock might go as high as $199, but when it does, many traders will sell, and it never goes over $200.
Of course, support and resistance levels change over time depending on market conditions and new information about the company.
If the company in the first example loses a major class action lawsuit, its stock price could well plunge below $100.
If the second company launches a terrific new product, its price could easily go above $200.
In the head and shoulders pattern, the neckline acts as the support level. When the price goes below the neckline, it’s a bearish breakdown.
In the reverse head and shoulders, the neckline acts as the resistance level. When the price goes above the neckline, it’s a bullish breakout.
Also called peak and trough analysis, peak analysis helps you see what’s happening in the market.
Price peaks represent the prices at which the selling pressure overcame the buying pressure.
Troughs represent the prices at which the buying pressure overcame the selling pressure.
A head and shoulders pattern indicates an interruption to the bullish trend because the right shoulder forms a peak that’s lower than the head. Once its price slide extends below the neckline, peak analysis confirms the bullish trend has been broken.
The best way I know of to carry out peak and trough analysis is to use Stocks to Trade. (I’m biased because it’s the trading platform I designed, so check it out for yourself.)
Head and Shoulders Neckline
The neckline of the head and shoulders pattern marks where buying pressure managed to overcome selling pressure …
It’s a straight line defined by the points of the two troughs.
The first trough is between the left shoulder and the head. The second trough is between the head and the right shoulder.
That’s a line of support (or resistance if you’re looking at a reverse head and shoulders neckline).
Head and Shoulders Pattern Target Price
You need to plan your trades out, including the target price where you’re ready to take your profits and get out.
How much profit can you reasonably expect from the head and shoulders?
Measure the amount from the peak formed by the head straight down to the neckline.
Let’s put that into numbers for an example:
The price at the peak formed by the head is $9. The neckline straight down is at $5.50.
Even when there were still more bulls supporting the stock’s price, it still dropped $3.50 until the bulls were strong enough to rally and stop it.
When it completes the right shoulder, breaking the support neckline, it most likely will slide even farther — but at least $3.50.
Key Tips on Head and Shoulders Pattern Use
Key tip: The head and shoulders pattern is so reliable, it’s hard to screw up.
The key is to recognize it in the first place. In real-life trading, the pattern is not as clear as an ideal picture. You can miss it until you train your mind to look for and spot it.
Usually, the pattern performs better when the peak of the left shoulder is higher than the peak of the right shoulder.
Always Use a Stop Loss
Set a stop loss. Set a stop loss. Set a stop loss!
If I’ve said it once, I’ve said it a million times. I say it in my sleep. I dream about telling my students to set stop-loss orders.
When I’m on my deathbed, it’ll be my famous last words. Always set a stop loss.
The headand shoulders pattern is powerful and reliable, but nothing works perfectly every time.
You can’t make the money you hope to make from trading if you go broke first.
Before you enter the trade, calculate your stop-loss target.
Never Trade too Big
You also need to protect your trading account by closely watching your position size. It’s part of my number one rule for trading penny stocks.
Never risk too much money on any one trade — no matter how fantastic it looks. No trade is without risk.
Going ‘all in’ on a trade by risking all your money looks dramatic in a movie, but in real life it’s just plain crazy.
You might win a few times, but sooner or later you’ll blow up. Sure as the stars above.
After 20 years of trading and with plenty of profits to cushion me, I almost never risk more than 20% of my trading account on one trade. And never more than 40%.
I recommend you keep your positions below 20% of your trading capital.
Unless you’re prepared to go back to your day job …
Would you like fries with that?
Improve Your Stock Market Knowledge
There’s one sure way to improve your odds of trading success: Increase your base of knowledge about trading and penny stocks.
You must be able to read a stock chart like a software engineer reads a computer program. Know it inside and out.
You can see where the stock has been, and understand what’s going on in its market. The supply and demand. The war between the bulls and bears. Whether it’s being pumped. And everything else.
You also have to understand your own psychology. Keep cool. Stay in control of your own mind and emotions.
All that comes with experience, so keep watching my videos, studying your trading journal, and learning from my top students.
I love the markets, and I love trading them.
But after I earned a few million bucks doing that, I discovered I loved teaching other traders even more, helping them make money from trading.
I still love to trade and make money. And whether I win or lose, I learn new things that I pass on to my students. Because I want them to succeed too. It’s my mission in life.
That’s why I’m inviting you to join my trading challenge.
The Bottom Line
There’s a simple reason the head and shoulders is the top chart pattern used by traders. It’s reliable.
You likely won’t see it happen frequently, but you should always be looking for it. Make it the first tool in your trading kit.
And it’s just one tool for you to master. You still need to know all the other important chart patterns and trading indicators too. Never rely on any one trading signal.
But this is one pattern every stock trader should know and recognize.