Identifying Head-and-Shoulders Patterns in Stock Charts

Look at any intraday stock chart and you're bound to see head-and-shoulders patterns—a central peak flanked by two smaller peaks—popping out all over the place.

These triple-peaked chart patterns can be useful indicators of a major trend reversal, but they're also among the easiest to misread. Indeed, many investors have paid a steep price for placing a trade without waiting for signals confirming the pattern.

To detect a true head-and-shoulders trend reversal, it helps to understand how they're created:

1. The left shoulder forms when investors pushing a stock higher temporarily lose enthusiasm.
2. The head forms when enthusiasm peaks and then declines to a point at or near the stock's previous low.
3. The right shoulder forms as the stock price rallies once again but fails to reach its previous high before falling again.
4. A fourth component—the neckline—is formed by drawing a line underneath the troughs established just before and just after the head. When the stock's price dips below this trend line, it's usually a strong indication that the pattern has broken, and it may be time to sell a position.

Note that inverse head-and-shoulders patterns—which are just the reverse, with the head and shoulders forming valleys instead of peaks—can also offer useful trading signals, but more on those below.

Even when the stock price breaches the neckline, it doesn't necessarily mean it's a lock to continue in that direction. To help confirm the trend, two additional factors are worth considering:

1. Volume: The number of shares trading is one indication of the strength behind a price move. With a classic head-and-shoulders pattern (chart above), you'll typically see trading volume start to lessen as the price moves higher toward the head and then again when it rebounds to form the right shoulder, indicating waning investor enthusiasm. A spike in volume when the price moves below the neckline suggests selling pressure will remain intense. If neither of these volume signals is in play, the decline may be short-lived, though there are no guarantees.
2. Time frame: Trend reversals require strong trends leading into them. One common rule is that the uptrend heading into the pattern should be at least twice as long as the distance between the shoulders. This makes it more likely that any reversal of the trend will be significant enough to trade, and that rule applies whether looking at an intraday opportunity or a lengthier one.

Now that you know what to look for, how do you trade it? By using some of the same risk-management tools that are part of your regular trading plan.

Stop orders, in particular, can be useful for head-and-shoulders opportunities, both for limiting your losses from downward price moves if you own the stock and for initiating a position in an inverse head and shoulders when the stock breaks higher through the neckline. However, be aware that there is no guarantee a stop order will be executed at or near the stop price. (For profit taking, consider placing limit orders at a predetermined target price.)

If you already own a stock and believe a traditional head-and-shoulders pattern may be developing, identify the potential neckline when the stock is forming the right shoulder and consider setting a sell-stop price just below it. For instance, if the stock retreated to $35, rebounded to a new high of $37, and then retreated back to $35 before climbing back up, one might set a sell-stop price just under the possible new support level of $35.

If you're looking to add a position, the formation of an inverse head and shoulders, with a stock price breaking above the neckline, often indicates a bearish trend has ended and the stock is poised for higher highs. In such cases, one might set a buy-stop price just above the neckline. For example, if the stock rebounds to $35, retreats to a new low of $33, and then climbs back up to $35 again before declining, consider setting a buy-stop order just above perceived resistance at $35.

An interesting feature of inverse head-and-shoulders patterns is that they can be used to estimate a profit target after the pattern is complete (chart below). To determine the target spread:

1. Measure the vertical distance from the head to the neckline.
2. Find the breakout point—where the price first breaks the neckline after the right shoulder forms—and add that distance to the breakout price.

Inverse head-and-shoulders patterns can help traders identify profit targets.

Some technical analysts believe this formula can give a good sense for how far the price could climb based on the size of the pattern and where a trader might consider setting a limit-sell price.

In my experience, those new to technical analysis tend to see head-and-shoulders patterns everywhere. That's why taking the time to confirm signals, such as volume and time frame of the preceding trends, is usually worth it. After a while, it'll get easier to separate the heads and shoulders from the head fakes.