We take our journey forward in understanding the various chart patterns that are usually responsible for reversal in trends. One such pattern is considered to be a very strong one and is widely seen in many charts. The head and shoulders pattern.
Head and Shoulder is another trend reversal pattern commonly seen in a candlestick chart. This occurs during an existing uptrend upon completion a downward trend is formed. The pattern makes 3 peaks with middle one known as its head, is higher than the other two on both of its sides. The other two peaks are known as the shoulders which roughly are equal to each other. The lows of each peak make a support level known as the neckline.
The prior trend: There must be an existing uptrend for a successful H&S pattern to be formed.
Left Shoulder: While in an uptrend, the stock prices make a new peak with heavy volumes and reverses from the peak to enter recession eventually making a low (with high volumes) which becomes the support level for the H&S pattern.
Head: The stock reverses from the support level (the low of the left shoulder as mentioned in the previous point) making an upward rally of prices reaching a level higher than the peak made by the left shoulder. After creating the peak, the prices would come down near the support level created by the left shoulder. Minute differences in the low are considerable however, the low should be made well below the peak of the left shoulder.
Right Shoulder: The stock reverses back from the low to make a high which is almost equal to the high of the left shoulder and lower than the head. In order for a complete reversal, the stock should fall back to the support line and breakdown the same.
Neckline: A line is drawn connecting the lows of the head and the two shoulders known as the neckline. A confirmation of trend reversal is received only after the neckline is breached (closing basis) and hence the head and shoulder are successfully formed.
Volume: Similar to other chart pattern, volumes play a pivotal role here as well. Ideally, but not always, the volumes during the rise of the left shoulder should be higher than the volumes during the advance in the right shoulder. Furthermore, the volumes should increase during the decline in the right shoulder providing for a strong reversal.
Price Target: The prices are expected to fall by a number that is equal to the difference between the head and the neckline.
Note: Once the support is broken, it becomes the resistance which in some cases may be tested, again providing an opportunity to sell.
Following is an example of an H&S pattern in L&T finance holdings
Price target in this case is:
75 (High of Head) - 69 (Neckline) = Rs 6
Hence, 69 - 6 = 63 (Price target) which was successfully achieved
Inverted Head and Shoulder
Opposite to the head and shoulder pattern, the inverted head and shoulder pattern is a bullish chart pattern. This pattern involves three lows which are; the low in the middle (or the head) which is the lowest of all lows and the two shoulders on either side which are a bit higher than the head. All the highs are connected with a resistance known as the neckline.
Prior Trend: The pattern can only be considered in an existing downtrend.
Left Shoulder: While in a downtrend, the left shoulder makes a low with heavy volumes and reverse back to complete the formation of the shoulder making a resistance line known as the Neckline
Head: After the left shoulder is formed, the price falls down from the neckline; the fall here is higher than the fall in the left shoulder. This means that the low made by the head is lower than the low made by the left shoulder. After making the low, there is a big rally in prices until it reaches the neckline created by the left shoulder.
Right Shoulder: After touching the resistance the price reverses back to create the right shoulder. Another low is made which is roughly equal to the low made by the left shoulder. The stock rises back from that point to complete the head and shoulder pattern after breaking the neckline.
Neckline: A neckline is drawn by connecting all the highs made by the shoulders and the head. A confirmation of the formation of this pattern is only received once the neckline is breached. This also results in the reversal of an existing downward trend.
Volume: Volumes during the second half of the pattern are more important than the volumes of the first half. The selling pressure in the fall of the left shoulder is heavier than the pressure in the fall of the head. The volumes during the rise of the right shoulder should very high; higher than the volumes during the rise in the head.
Price Target: The stock is expected to rise by an amount (from the neckline) that is equal to the difference between the head and the neckline of the pattern.
NOTE: While executing trades using such patterns, a conservative approach should be taken. This means that your own target should be at 75% of the projected price difference that is expected from the pattern rather than waiting for the full 100%.
An Example from the market.
Price target here is the difference:
1565(Neckline) - 875 (low created by the head) = 690 points
Hence, the stock is expected to reach Rs. 2255 (1565 + 690 = 2255)
The stock reached a level of 2,198 and reversed; hence, as mentioned earlier a safe target of 75-80% of the actual target is always recommended.
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