Yes, most people think “shampoo” when they hear “Head and Shoulders,” but traders aren’t most people.
In trading, a head-and-shoulders pattern forecasts a potential reversal from bullish-to-bearish trading, and is thought by many technical traders to be a particularly reliable indicator. Let’s take a look at how to spot this pattern.
Spotting the head-and-shoulders pattern
There are three main phases to a head-and-shoulders pattern. First, you’ll see a stock have bullish trading activity, hit a peak and pull back to form a trough at a support area. Next, the price rebounds off the support level and forms a higher peak, but pulls back again to the support area. Then the price rises yet again to a high around the level of the first peak, only to pull back to support one more time.
At that point, if the stock breaks below the support area, it could continue lower.
Let’s take a look at an example using the SPDR S&P 500 Index ETF (SPY)
In the chart above, notice that the first “shoulder,” or peak, was formed after an uptrend in the exchange-traded fund. Thereafter, it pulled back and formed a trough at a support area. Following that, the stock rebound and formed the “head” of the pattern. Again, it pulled back to support level, and rebounded to form another peak. After that, however, it pulled back again and broke below the support area. Consequently, this signaled to technical traders that a bearish move might lay ahead for the SPY, and the ETF sold off.
Head-and-shoulders patterns can be a useful tool in your trader toolkit, but keep in mind that this pattern does not always work, so keep expectations in check. Still, if the stock breaks below the support area — the pattern’s neckline, if you will, there is a high probability that the security is about to take a fall.
Jason Bond runs JasonBondTraining.com and is a swing trader of small-cap stocks.