Head and Shoulders is one of the most known and successful pattern in money markets. It always appears where the price is reverse, means that when price move in uptrend and its about to go down, or the other way when price moving in down trend and the price want to reverse to up trend. It also appears in different time frame which means that you might not notice this pattern in daily time frame but when you go deep and search for it in lower time frame such as 4 hours, one hours or may be 15 minutes time frame you will notice it.
First I am going to put a picture for real chart of price movement in one of financial market that has the head and shoulder pattern, and then I am going to explain the philosophy and psychology behind this pattern and its formation and why it is so profitable.
As you can see from the above chart for Apple stock. The stock moved from almost May 2018 at price 141 $ to reach its top in March 2019 which was 230 $. It took the stock just three months or about to reach its starting price which was 141 $ and that after a successful formation of Head and Shoulder pattern. That means if someone was watching this stock closely and found that this pattern formed and short/sell Apple Stock at the right shoulder, she would make in three months as much as the one who bought this stock one year ago.
But in order to master this pattern and know where is the right moment to enter trade like this you have to know the psychology and the other traders emotions that helped the price to move that way and formed this pattern. And here we are:
- The price moves in regular up trend where its formed higher lows and higher highs as the picture below.
- The price moved from point 1 going up until it reach a resistance in point 2 and then drop in pull back movement. (as figure below shows)
- When price reached point 3 which considered as support, price continue its movement upward until it reached point A.
- When price reached point A it find a resistance there which was stronger than the resistance found in point 2 which made the price dropped in strong move down than the previous one that made price dropped from 2 to 3, and then point B formed which worked as support and helped price to move up.
- In the price movement from (A to B), the price found strong sell momentum that made it drop strongly than the previous drop from 2 to 3, this momentum can consider as high sell volume but not greater than the volume that made price go up from point 3 to A.
- Then price which found support in Point B go up slowly to point C, and when I said slowly I mean that this movement lack the momentum and/or high volume. Always this movement has MACD bearish diverging and/or RSI bearish diverging which means that the price in C is higher than A, while the two assigned points for A and C in MACD and/or RSI are going in down trend as shown below.
As you can see in the above figure the price of Apple stock made new high and uptrend while the MACD and RSI were making down-trend, and this is what I meant about bearish diverging which is a good sign but not the only one for Head and shoulder formation.
Back to our pattern explanation:
- Once the price barley reached point C, it will drop with high momentum and strong volume to reach point D. This high momentum and strong volume helped the price to break the up-trend pattern and formed the first lower low in the pattern which is point D.
- Once point D is formed, the wise trader who followed the trend will reconsider her positions, and think hard to either keep her position or exit this long position that she entered in point 1. But she still waits for good bargain and good price to sell her share. She does not trust this up trend pattern anymore specially when there was a contradiction in the main principle of uptrend which is forming higher highs and higher lows, and now there was new lower low which formed in point D. Even if she does not know any thing about volume or momentum or how to read it, but she only knew that this contradiction in the price movement that lead to form new lower low does not make her feel right and the market is going to do something else but not going up. At this point this wise trader will decide to exit her long position as I said that she entered in point 1, but she will wait for right moment to exit with maximizing her profit, and that will happen only when price move up and reached point E and failed to go more further than that.
- At that time she will know that this price is either going to go sideways or down which will be no good for her, and she with other wise traders who think the same way decided to exit their long positions that they entered in point 1 when price reached to point E which is another contradiction for up trend when price formed lower high.
- The price will reach point D with low volume and low momentum which prove this movement was just a reaction to the previous strong movement that made it drop from C to D. Once those wise trader exit this long move started in point (1) especially after they see price started forming lower highs and lower lows which is a sign for down trend, their exit will combined with the high momentum and volume of sellers who caused the up momentum of previous up-movement from 3 to A and from B to C to fade , and only then the price will drop in strong movement from D to reach the same level that it started with, which was point (1). This is exactly what happened in Apple’s stock movement in the previous figure.
But how can trader make sure that the head and shoulder pattern has been formed and its good time for trading this pattern and making some money, this is what I am going to show in the coming points:
- First of all, the trader must make sure that the pattern has been formed and satisfied the following point with accuracy not less than 90% or more, if it is less than that she must not enter this trade as head and shoulder pattern formation. And these points are as following:
- The price should go down to point B in strong move, stronger than the movement that made it stop in point 3.As shown in the previous figure.
- The movement that took price up after that to pint C should be equal or less stronger than the previous movement that took price down to point B. That means the bearish has a strong power that equal to or greater than the bullish which made strong believe that they are able to take the price down.
- To make sure that point 3 is satisfied the next down movement for the price will make new support point which is lower than the support in point B, which is D and this point will make sure that those traders will have confusing and the long position they entered is no more valid and they should re-consider their position by exit it and take their profit.
- Those long traders who decided to exit their long positions will hold those position to get the maximum profit by waiting until the price reach point E. The price movement to point E will have lower and weak movement compared to movement from point C to D which means the price moved as consolidation or reaction to the bearish movement and the bearish just resting and willing to take the price down again to make new lows.
- Once the price barley reached point E with low momentum and weak volume the bearish will took the control and drive the price down again and the price will be ready to broke all down levels and reached to the place where all this was starting to the beginning of this up movement.
Here is some other considerations about point ( A, E) which consider the two shoulders of this pattern as well as points (B,D) which consider the Nick-line for this pattern:
- Point E (right shoulder) should reach the same level as point A (left Shoulder) which means that point A should work as Resistance for point E and prevent it from going higher than this level, and its totally recommended to have down trend between these two points. (as shown below between left and right shoulders).
- The same is true for point B and D, it’s totally recommended to have down trend between these two points as shown in the figure below:
Finally, head and shoulders is not that famous pattern as other patterns, but once this pattern started forming, trader should pay clear attention to it to make sure its completed all its characteristic explained above, because it will be completely profitable for traders of all markets types. This pattern can be found in revers way which called “Revers head and shoulders” pattern which make markets reversing from down-trend to up-trend. The same principle applied in head and shoulders pattern can be applied in Reverse head and shoulders pattern but instead of sellers taking controls in head and shoulders pattern, the buyers will take the control and will take the price from low prices to more higher prices in revers head and shoulders pattern.