Five Chart Patterns Every Trader Should Be Able To Recognize (Part 5)

04/11/2008 12:00 am EST

Focus:

Head & Shoulders / Reverse Head & Shoulders

Usually found after a long trend either up or down, as its name suggests head and shoulders are named after the human form. Consisting of three peaks, one of which (the head) is centered and higher than the two lower and relatively equal peaks (the shoulders). Head and shoulders is perhaps the most well-known reversal pattern within technical analysis. Formed after a long upward trend the left shoulder begins to form while still in the upward trend. Essentially the left shoulder forms as prices rally up and quickly thereafter retrace, typically the upward trend line, or resistance level will not be broken as this happens. Notice that the left shoulder seen alone can also be viewed as a forming flag. As the left shoulder finds its end, prices again rally, this time to a new high, which will become the head of the pattern. After the high peak or head of the pattern is formed and prices have retraced back down, again prices will rally to near the same level as the left shoulder to form the right shoulder.

Essentially, within an upward trend prices have attempted to rally three times and each rally has seen limited success, or in other words has been rejected by the sellers. Once the right shoulder breaks through the imaginary support line equal with the right shoulder (the neck line) the reversal of the trend has officially begun. Buyers have tried to continue the upward trend, and three times have lost their battle to the sellers. A trader who has spotted a forming head and shoulders pattern can usually be quite sure that he or she has seen the end or a long upwards trend. It’s time to cut your losses, secure your profits, or short the market.


Every pattern within technical analysis seems to have its opposite, head and shoulders is no exception to this rule. Reverse head and shoulders represent essentially the same situation as normal head and shoulders, but of course are found in long term downwards trends as opposed to long term upwards trends. Instead of the head and shoulders represented by new peak highs they are represented by new peak lows. The reverse head and shoulders tips the trader that the downward trend is losing steam as three new lows have been tested and each time bested by the buyers in the market. Again, it’s time to cut your losses, secure your profits, or this time, long the market.

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