Where you are going wrong in Head & Shoulders Pattern.
The head and shoulders pattern is one of the most commonly used pattern by many traders. For the starters, let's discuss what is this pattern and how does it looks like. It's a three-valley formation with center valley is lower (in case of Head and Shoulder bottom- short term bullish reversal) or higher (in case of head and shoulder top- short term bearish reversal) than the others. The term head and shoulder is named due to the kind of appearance it gives, i.e. it looks like head and shoulders ( left and right) of a person. (chart 1)
Now comes the point which is most interesting, what makes this head and shoulder pattern form?
Like other reversal patterns, head and shoulder pattern forms as a result of the institutional traders entering into the market and placing their respective trades which makes the market reverse. The difference which this pattern creates is the manner they enter the market, which makes the prices move in such a way that it appears to be a person's head and shoulder. As they (institutional traders) cannot enter the market at once, they observe the market and enter in parts so that every time they enter, they make sure to place the order at a similar price to one another. Coming back to head and shoulder pattern, here I will be discussing the bullish reversal Head and shoulders pattern for explanation purpose i.e. Head and Shoulders Bottom (Chart-2). At the lowest price which represents the best value for the big traders, institutional buyers buy the stock in increasing numbers or have closed some of the short trade, which makes the prices climb and start forming a left shoulder. Selling supply moves the prices lower than before as sellers are still in control which completes the left shoulder. At this price, near about which institution bought earlier, they again enter as the lower prices are favorable for them, forming the head which is backed up with closure of pre-existing sell positions because it makes the investors panic as prices move up due to huge volume trades taken by institutions. The major reason for head of the pattern is due to volume trades of institutions. Similarly, right shoulder is formed when stock moves up, but only difference is that the volume on these three troughs is diminishing. This factor is very important to recognize a successful pattern in formation. This means, on left shoulder there will be high volume, then there will be comparatively less volume during head formation and least in right shoulder. Once the price starts moving up from right shoulder for breakout, the volume spikes. The resistance line where the left shoulder, head and right shoulder rest forms the neckline i.e. line connecting two shoulders, used for breakouts and entering into the trade.
Now after we know how the Head and Shoulder pattern forms , there are certain important features for having a successful trade through head and shoulder pattern :-
1. Harmony :- The left and right shoulder should be in harmony. This means both should mimic each other, in price and time taken to form the shoulder, not necessarily an mirror image but in symmetry. There are variations like in complex head and shoulder patterns but more the harmony, more is the validity of the pattern.
2. Shape & Neckline :- This is a formation of three troughs forming left shoulder, head and right shoulder. If left shoulder is sharp or pointed, right shoulder will also be sharp, i.e. left shoulder is at about the same price and same width as of the right one. The neckline connects the right and left shoulder and it can be straight or slope going up or down or steep but for a well formed pattern neckline should be less steeper.
3. Volume :- This is one of the most important feature. It validates the pattern in priority. The volume is at highest at left shoulder or head and diminishing on right shoulder. At breakout, the volume is usually high which brings the price above the neckline. Pattern with diminishing or U-shaped volume performs well.
4. Breakout & Gaps :- Breakout is at neckline or highest high in the pattern (for bullish reversal) and lowest low in the pattern (for bearish reversal). Gaps are very helpful during breakout days.
After knowing the basics and supporting features of the pattern, let us have a look at the reasons for failures (Chart-3). There are two types of failures in this formation. First one is non supportive volume during the formation of pattern i.e. low volumes at the left shoulder and/or head in comparison to right shoulder. This does not necessarily invalidated the formation but sets an alarming signal for a doomed pattern. Second reason is the underlying risk prevailing in trading which says that these patterns are not a fool-proof way with 100% accuracy every time . It includes single or combination of reasons like unusual volume at right shoulder or unusual formation of left and right shoulder and so on.
Thus, this pattern is worth betting as because of it's clear and set rules of features, makes it one trustworthy pattern, keeping in view the formations and confirm closes on the neckline. In case you miss a trade at breakout, half a time, the stock moves back to the neckline to give you another chance to enter or if you already are in the trade then to add up to your position (Chart-4). Stop-loss is to be placed at lower/higher of the two shoulders as prices drop/jumps till shoulders sometimes before going in the meant direction. Tall and narrow pattern works better than short and wide pattern. Patterns in bull market shows lowest failure rates. So, calculate the risk, follow the rules and happy trading !