The head-and-shoulders pattern is sometimes seen on price charts ahead of a downside reversal. It occurs after an uptrend and consists of three peaks in price, with the center peak being higher than the other two. The two "side" peaks should be about equal in height.
The three peaks give the pattern its name, with the center being the head and the right and left being the shoulders. Connecting the bottom of the peaks is what is called the neckline, and a break of this support level is the signal that the uptrend is reversing.
Chart patterns have been documented in books and articles since the 1930s, and the head-and-shoulders is among the most famous. Several studies since the 1990s have demonstrated that the pattern works to identify market turning points. In one of the first studies, economists at the Federal Reserve said it was "not just a flaky pattern." Since then, a number of respected academics have reached similar conclusions and agree that traders can obtain profits by using the pattern.
How Traders Use It
A head-and-shoulders pattern can be used to time sells in the market. Traders have found that the pattern can work in any market, and many traders look for the pattern in stocks, futures and foreign exchange markets.
The daily chart of the British pound shown below is an example of a tradable head-and-shoulders pattern that formed in late 2009. This example includes a throwback, price behavior that is commonly seen.
After breaking down through the neckline, prices often trade back up to that level, and the move back toward the neckline is called a throwback. Throwbacks also illustrate the idea that support (i.e., the neckline), once broken, becomes resistance.
In addition to providing trade timing signals, price objectives can also be obtained from the head-and-shoulders pattern. The measuring rule is to expect a decline equal in size to the range from the neckline to the high reached at the top of the head.
In the chart above, the decline failed to reach the objective before the throwback. Prices rallied back to the level of the neckline before falling lower and eventually reaching the downside objective.
Why It Matters To Traders
In addition to providing trade timing signals, the head-and-shoulders pattern offers price targets, and there are few tools that traders can use to project how far a price move should go. This makes the pattern very useful for assessing how close we might be to a bottom. Once the price objective has been reached, traders may take long positions with more confidence.
Chart patterns like the head-and-shoulders can be used as a trading strategy, or they can be combined with other indicators to develop a more detailed view of the markets. Either way, this pattern has allowed many traders to profit over the years.
(This article originally appeared on ProfitableTrading.com.)