The head and shoulders pattern is a technical analysis pattern that is used to predict the reversal of an ongoing trend, usually from bullish to bearish.
Here's how it is typically used for trend reversal:
- Formation: The head and shoulders pattern consists of three peaks, with the middle peak (head) being the highest and the other two peaks (shoulders) being lower. The peaks are separated by two troughs (valleys). The pattern resembles a person's head (the middle peak) and shoulders on both sides (the other two peaks).
- Breakout Confirmation: The pattern is considered confirmed when the price breaks below the neckline. The neckline is formed by drawing a line connecting the two troughs (valleys) that separate the peaks. The breakout confirmation indicates a shift in sentiment from bullish to bearish.
- Trend Reversal: The completion of the head and shoulders pattern suggests that the previous uptrend is likely to reverse. It indicates that selling pressure is increasing, and buyers are losing control. Traders interpret this pattern as a bearish signal and expect the price to decline.
- Price Target: To determine the potential price target for the upcoming downtrend, traders measure the vertical distance from the neckline to the head (highest peak) and project it downwards from the breakout point. This provides an estimated target for the downward move. However, it's important to note that the price may not always reach the target, and other factors should be considered for a comprehensive analysis.
- Stop Loss: To limit potential losses in case the pattern fails, traders often place a stop-loss order just above the neckline after the breakout. This helps protect against any false breakouts or subsequent reversal of the downtrend.
It's important to remember that the head and shoulders pattern is just one tool used in technical analysis. Traders should consider other indicators and factors to validate the pattern and make well-informed trading decisions.