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Hey, this is Sasha and welcome to another episode of Let's Talk Stocks.
Today, we're going back to some technical analysis basics, and we're going to take a look at the head and shoulders reversal pattern.
We'll take a look at:
- what it looks like,
- the previous trend,
- volume projections,
- the entry point, and
- a few tips.
When we look at this pattern, typically I've seen this pattern be a little more bearish than really bullish. But there is an Inverse Head and Shoulders pattern which would be more of the bullish way or the bullish pattern where it goes to the upside. But I've seen it more in the bearish context.
The bearish pattern looks like this
This is a reversal pattern. We're going to roll it over. It goes up like this.
We create a little bit of one single peak here then what ends up happening is the stock pulls back and then it will create another more prominent peak. Finally, a third peak.
Over here, this creates a little bit of a neckline. This stock then breaks through, comes back, often retest, and then it'll go lower. This is what the head and shoulders pattern looks like.
This is one shoulder over here. This is another shoulder. Here is your head right there. That's why it's called a head and shoulders pattern.
Typically, this first peak compared to the second peak is a little bit higher. That's just because this shoulder can slouch a little. Meaning, buyers are not stepping in as much into this second peak.
What is happening?
You have this influx of buyers coming in initially.
They say hey well price is getting a little too high so they go ahead and you know they start selling, and then other people get in due to the value and that creates another influx or wave but is there's not enough of them.
When there's not enough of them, that stock again continues to pull back and they recognize that hey this could be a topping out point, so on that next bounce it may not reach those high peaks anymore.
That's why it then rolls over.
We break that supporting neckline, which your support level. We may come back and retest this and then further roll back over.
That's your Head & Shoulders Reversal Pattern.
If we take a look at the volume, often, you'll get the right amount of volume initially as you start to head higher.
Then, as you start doing these pullbacks, the volume will slowly shift from being more strong during the upward movements, or the bullish parts to it'll shift more into being stronger.
As you start selling off, especially here as you get into this breaking area, it's going to be stronger volume as you break that support.
Watch for that strength on that break right there as well could be a little bit strong on the volume and anytime you get these pullbacks and that should also continue to increase.
Otherwise, the volume could be a little flatter. You could also see things dry out a little bit because this is distribution.
The key points are
You'll get a high peak volume as you're going up but then to change direction. You need that volume to shift more to the bearish side slowly.
That's why as you start these sell-offs and pullbacks, that volume should start to pick up.
Your projection and the goal of this pattern is as far as the distance goes.
If you take from the head here draw a line down to that neckline, so looking at it this way, you're going to do about the same on that from the neckline all the way down to this level. Your target will be about the same distance from the top of the head to the neckline.
If we're looking for entry points potentially to get in, this, of course, is a shorting pattern, so you're going to short. You have a couple of opportunities here, but this will be entry point number one when it breaks kind of that neckline.
If you miss that, you could take a look at entry number two - where you break and retest this resistance level now. In the past that was support, but then it becomes resistance where it rejects, and it follows through.
But again, this is for shorting the stock. It's not for a bullish movement. That's the thing with these patterns.
A little quick tip
Just watch this second shoulder, whether you're doing a bullish or a bearish pattern.
Watch the second shoulder that sometimes it slouches a bit simply because you don't have enough movement on that second bounce. There's not enough volume maybe coming in or not enough buyer so that it may be a little bit smaller.
Sometimes, that neckline can also be a little bit angled. You might see it a little bit sloped a little this way. These bounces where they come in could be a little bit in a diagonal fashion as well.
If we take a look at the bullish side.
It looks very similar except it's coming down from the higher prices.
What typically happens is this
Again, you'll get your one peak or bounce, and you'll get another one there's your head okay, and then still there's your shoulder. Your neckline will be right about here.
As that stock breaks out, you might see it retest. They'll move something like that.
Your head will be right here, and these are your neck areas and again the distance, if we're looking at a distance, you're just drawing kind of the distance between the head to the neck, and then again you're looking for kind of your target right there.
If you're looking for entry opportunities on the bullish side, of course when it breaks, this is the more usual one people trade because this is looking for an extended opportunity. This could be your entry point.
Another one is if it comes back and bounces, that could be your second entry point right there.
Anyways, that's the head and shoulders pattern.
The bearish one is a lot more common. The bullish one, you're going down and having a very strong pullback and then it kind of reverses.
In a way, sometimes this could also be a consolidation pattern if you start looking at it a double bottom, triple bottom. In a way, it starts to disguise itself.
What you call it, is up to you. It is just really the pattern. If the head is further down below a consolidation area, then it'll be a Head & Shoulders pattern.
If they're more in alignment, it'll be a triple bottom.
That's just a name that we give it to reference and discuss these patterns quickly, but overall it's only a consolidation period where it provides the stock with time and room to digest the sell-off to be able to shift direction and reverse.
Same thing in the bearish pattern.
Here, you're moving to the upside. You're digesting. Give it time and room and then it sells off further. Anyways, watch these patterns. You're just looking for areas of support/resistance.
Sometimes, if they breakout above things and you'll notice hey well the stock broke out, and you let's say tried to get in over here.
But then, it rolled back over, and you lost out on that trade. It may start to become a head and shoulders pattern because you tried to get in on it but it went a little higher, and it's real instead of a horizontal resistance area it went above it because of that headline.
Then again, you'll see how it evolves. It's just a little clue and tip for you. If you're getting into a trade and it just rolls over a little bit after that, it could turn into a Head and Shoulders pattern.
Take a look at a couple of Head and Shoulders patterns
This one we have is ATI, and I want you to put your attention towards the center of the chart here around March to July.
We have one shoulder that's being created here on the left area right around March. Then around May, you have the head that's being created, and then you also have the other shoulder that's around July timeframe right there.
If you combine the two shoulders, you get a little bit of a descending trendline there between the two shoulders, your neckline or kind of the support line would be right under those armpits. You can almost say that that's a triangle pattern, but it's not a triangle pattern because you have that head above there.
Your entry opportunity will be just under or below that neckline. Going right under around the 56 levels in July, that'll be the shorting point.
You can notice the volume also starting to build as we increase the selling pressure.
Anyways, that's a head and shoulders pattern on ATI.
Here's another head and shoulders pattern on Caterpillar but it's inverted.
If we take a look at this one right here, the stock trend is going down. Again, this is a reversal pattern if we change direction. That's what the head and shoulders are going to do.
There's our head in 2009 around February, and then we have the other shoulder around June/July.
This neckline is a little different. Again, it could also look like a triangle pattern, but because we have that head, it's not going to look that way.
So, the descending trendline is what you're watching for, which is that neckline. You're looking for it to break and when that breaks, that would be your entry point right around that time frame.
You'll also notice the volume slowly starting to build as we do the breakout. When we are in the head and shoulders pattern, the volume is declining a little bit. Anyways, that's a little bit of a head and shoulders pattern for you that you can also take a look at.