May 24, 2013
A trader’s look at Head and Shoulders Formation
Inverted Head and Shoulders
Head-and-Shoulders Formations
A head-and-shoulders pattern is one of the most common formations referenced and championed by non-chartists. It might be difficult to see the suggestion of an actual head and shoulders of a person, but that’s the genesis of the name. Although it requires a little imagination to picture it, that’s exactly what charting is all about.
This chart tells the trader two things: first, the top is probably in and the trend is changing; second, it gives us a way to measure the length of the move. Note the length from the “head to the neckline”, then measure the same distance below the “neckline” and calculate a downside objective. Entering the market when it breaks the neckline is difficult, but it’s the correct thing to do. A stop-loss inverted order should then be placed above the “right shoulder”. The head-and-shoulders formation is just the reverse of the top. Using the same type of measurement when the market breaks above the “neckline will yield an upside objective.
Unfortunately, price objectives do not come with guarantees. This is particularly true for head-and-shoulder formations. The objectives will generally be achieved 60 percent of the time, which puts the odds in the trader’s favor. For the other 40 percent of the time, it is imperative that you learn to recognize when you are wrong and quickly reverse a trade. It is also important to be flexible and to be aware of other chart formations, such as the triangle.