Pattern – Part1: Head and Shoulders

Analyzing candlestick charts, it is possible to identify patterns, or figures, that allow us to hypothesize, with a certain probability, the price trend.

The patterns are divided into two large families : trend inversion patterns and continuation patterns.

The main inversion patterns are:

  • Head Shoulders
  • double minimum / maximum
  • triple minimum / maximum
  • maximum / minimum rounded off
  • Formation of a V

The main continuation patterns are:

  • Triangles
  • Rectangles
  • wedges
  • Flags and Guidons

We will divide the treatment of the various patterns into more articles.

HEAD AND SHOULDERS

The head and shoulders is one of the main inversion patterns , and it is also the one that, if completed, is most likely to predict an inversion.

In the event of an uptrend , the basis points are as follows:

  • existence of an up-trend;
  • subsequent occurrence of exaggerated increases;
  • three consecutive rises (the two shoulders and the head).

More in detail, the figure is formed as follows:

  • Left shoulder:
    • shape: the wave follows the previous uptrend;
    • volume: they are high at the beginning, until there is a downsizing given by the meeting between supply and demand;
  • Head :
    • shape: has a wider movement than the shoulder;
    • volume: volume are on average lower than the left shoulder. In fact, a divergence between rising prices and falling volumes is created, leading to the downsizing of prices which creates a relative minimum;
  • Right shoulder :
    • shape: formed for the most part due to sales made in the previous downhill phase;
    • volume: growing.

It is important to know that starting from the minimum of the left shoulder and arriving at the minimum of the head you can trace the neckline .
The neckline is important for the following reasons:

  • the figure is completed when the neckline is clearly exceeded;
  • the probability of this figure is also due to the divergence of the inclination of the neckline with respect to the trend of origin;

Image1 : schematization of head and shoulders with volumes

 

The head and shoulders can also be in horizontal phases but with less clear consequences.

The occurrence in the case of is also interesting   bearish trend , in which one has abottom head and shoulders.

The graphic formation is similar but overturned, in detail:

  • The left shoulder is formed as a result of a decrease in prices that occurs with volumes sustained and subsequently with a recovery in prices with low volumes.
  • The head has a further decrease in prices, accompanied by very low volumes.
  • Finally, the right shoulder is formed with sustained volumes, which increase even more once the neckline has been overcome.

The bottom head and shoulders usually occurs at the end of a primary descending trend.

Image2: schematization of head and shoulders bottom with volumes

 

References:

  1. Ettore Coliva, Lucio Galati, “ANALISI TECNICA FINANZIARIA”, 1th edizione del 1992, UTET Libreria (Pag 59 – 113)