What Happens After a Head and Shoulders Pattern?

Understanding the Head and Shoulders Pattern

A Head and Shoulders pattern is a distinct chart formation in technical analysis, often signaling a potential reversal in an asset’s price trend. This pattern typically forms after a significant uptrend, indicating a shift from bullish to bearish sentiment, or after a downtrend, suggesting a move from bearish to bullish. The pattern is composed of three peaks, with the middle peak (the “head”) being the highest, flanked by two lower peaks (the “shoulders”) on either side.

A trendline connecting the lows of the two troughs between the shoulders and the head forms the “neckline,” a crucial component of the pattern. The Inverse Head and Shoulders, appears after a downtrend and suggests an upward reversal. Both versions provide a framework for anticipating future price action, making them valuable tools for market analysis.

Confirming the Pattern

Confirmation of a Head and Shoulders pattern relies on specific price action and volume characteristics. The most important signal is a decisive break of the neckline. For a standard Head and Shoulders top, the price must fall and close below the neckline. For an Inverse Head and Shoulders bottom, the price must rise and close above its neckline.

The breakout from the neckline should be accompanied by a noticeable increase in trading volume. This surge in volume reinforces the pattern’s validity, suggesting strong conviction behind the new directional move. Without a significant increase in volume, the breakout may be less reliable, potentially leading to a false signal or a less sustained price movement.

A confirmed break typically involves the price closing below the neckline on a daily chart, often by a certain percentage or a few price units, to avoid false signals caused by minor fluctuations. A break below the neckline for a Head and Shoulders top indicates that supply has overcome demand, pushing prices lower. This confirms the pattern’s completion and signals the probable start of a new downtrend.

A break above the neckline for an Inverse Head and Shoulders bottom indicates that demand has overcome supply, pushing prices higher. This confirms the pattern’s completion and signals the probable start of a new uptrend. The neckline, once broken, often reverses its role, acting as a level of resistance in a downtrend or support in an uptrend.

Observing multiple daily closes beyond the neckline can further strengthen the confirmation of the pattern. A single close beyond the neckline might be subject to a quick reversal, so waiting for additional confirmation can help reduce risk. The depth of the breakout, measured by how far the price moves past the neckline, also contributes to the pattern’s confirmation.

Projecting Price Movements

Once a Head and Shoulders pattern is confirmed by a decisive neckline break, technical analysts employ a standard methodology to project a potential price target. This projection technique provides an estimated range for the subsequent price movement following the pattern’s completion. The primary step involves measuring the vertical distance from the peak of the “head” to the neckline. For an Inverse Head and Shoulders pattern, this measurement is taken from the lowest point of the “head” to the neckline.

This measured distance represents the anticipated minimum price movement once the pattern breaks out. After determining this vertical distance, it is then projected from the point where the price decisively breaks the neckline. For a Head and Shoulders top, this measured distance is subtracted from the breakout point on the neckline, providing a downside price target. Conversely, for an Inverse Head and Shoulders bottom, the measured distance is added to the breakout point on the neckline, indicating an upside price target.

For example, if the distance from the head’s peak to the neckline is $10, and the neckline breaks at $50, the projected price target would be $40 for a Head and Shoulders top. While this measurement offers a useful target, it is important to remember that it represents an estimate rather than a guarantee. Market conditions and other factors can influence the actual price movement.

The projected price target serves as a guide for potential profit-taking or risk management strategies. Analysts often consider this target as a minimum expected move, with prices potentially exceeding it if the underlying trend gains strong momentum. The precision of this projection depends on the clarity of the pattern’s formation and the accuracy of drawing the neckline.

Common Post Breakout Dynamics

Following the confirmed breakout of a Head and Shoulders pattern, specific price dynamics frequently unfold. One common occurrence is a “retest” of the neckline. After the price breaks through the neckline, it may often pull back to touch the neckline again, which now typically acts as a new level of support or resistance. For a Head and Shoulders top, the broken neckline, which was previously support, often becomes resistance during the retest.

Similarly, for an Inverse Head and Shoulders pattern, the broken neckline, which was previously resistance, often becomes support during the retest. This retest provides an opportunity for market participants who missed the initial breakout to enter the new trend. The price typically bounces off the retested neckline, confirming its new role and continuing in the direction of the breakout.

The retest can occur within a few days or weeks after the initial breakout, and its success in holding the new support/resistance level strengthens the pattern’s validity. After the retest, or sometimes without one, the price generally continues its movement in the direction indicated by the pattern. For a Head and Shoulders top, this means a continuation of the downtrend towards the projected price target and potentially beyond.

For an Inverse Head and Shoulders, the price typically continues its uptrend. The momentum following the breakout can be significant, especially if the initial volume surge was substantial. The post-breakout phase often involves the establishment of a new trend channel or a sustained move in the new direction. While the projected price target provides an initial objective, the market may continue to move beyond this point if the fundamental drivers or broader market sentiment support the new trend.