Let’s take a minute to chat about the Head and Shoulders pattern. It’s probably one of the most widely used, talked about, and commonly dissected chart setups on Earth and for decent reason. In my experience it’s a reasonably reliable chart setup if you follow the actual rules around it. Importantly, there’s some pretty basic market psychology to back up the setup. We really never want to pay attention to TA theories that can’t tie back to real actions or motivations in the real world, so this ticks off those boxes.
Head and Shoulders Defined
A Head and Shoulders pattern is defined by an increase in volume and price of an underlying followed by a drop. Then the price of the underlying goes back up but higher than the peak it just hit and with lower volume, again followed by a decline. The decline is stopped at or around the same price as the higher low created by the first price pop, resulting in another increase with even lower volume. The Head and Shoulders pattern is known as a reversal pattern. That is to say, if the Head and Shoulders forms with a higher head than left shoulder, the right shoulder would indicate a potential bearish turn upon completion.
The Psychology of Head and Shoulders
As I say a lot, if TA doesn’t tie back to the actual actions of human people in the market on some fundamental level, chances are great that it’s bullshit. So what are the basic market actions at play in the formation of this setup?
In the initial run-up you have price action being driven by volume. This can be catalyst-driven or can be driven by a number of other fundamental factors. The end result is that price turns bullish and its action is driven by market participants actively trading the underlying.
The head formation has comparatively very little volume, even on the sell-off side of the formation. Market participants who were gobbling up the stock are not buying and not selling enough for the price to be driven by volume. As a result you see the price rise in a somewhat inflated way because there are more buyers than sellers but very few of either. If 10 people want something only 5 people are willing to sell, you won’t have a lot of sales but the 10th person will be paying a hell of a lot more than they should by the end of it.
The last run up (the right shoulder) is more or less the same, but with lower volume-driven price action as market interest in the underlying wanes. The pattern finalizes as the “run” appears to be over, participants exit, and there are substantially more shares being sold than bought which leads to a precipitous reversal in the stock price.
What People Get Wrong
The number one thing that people seem to forget about Head and Shoulders is the volume component of the setup. If you have a pattern that looks like a Head and Shoulders on the price chart but where the volume isn’t correct, then you straight up do not have a pattern that is a Head and Shoulders.
So for example, let’s say you have a stock that looks like it’s forming a right shoulder to complete the setup.
This is the chart for $BF.A (Brown Forman’s Class A shares):
You can see the chart shares a bunch of the same cosmetic traits of a Head and Shoulder pattern if you don’t look at the volume. I wouldn’t even discount this setup as a Head and Shoulders if the volume was right despite breaking the neckline a bit there, your pattern finding needs to have tolerances for odd price action (news, etc) and the price recovered fast enough I would discount that. I wouldn’t hold it against you if you didn’t.
However, the real story here is in the volume. The price was buoyed by an increase in volume when the “head” was formed with a ton of volume on the sell-off side of the formation, which means this is likely more of a continuation pattern than a reversal pattern. You can see this was the case as the price did not reverse down toward the lower low, rather it rocket shipped off the neckline.
Summary
As with any chart setup, indicator, or anything else you use, nothing should be used on its own. Everything should be used in context and no one thing is a perfect indication of future price action.
When you decide that you want to trade on chart setups and patterns like this, it’s important that you’re taking the time to not just get a cursory understanding of the pattern. You have to make sure you’re getting the fullest view of the strategy possible. Otherwise you’re just playing make believe looking at charts and probably losing a lot of money in the process.
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If you thought any of this was useful please make sure to subscribe to my Substack (link below) for lots of this type of content. I also do regular market commentary on my Twitter account (link below) so it's a good idea to follow that if you enjoy the kind of content I put out.
Head and Shoulders Defined
A Head and Shoulders pattern is defined by an increase in volume and price of an underlying followed by a drop. Then the price of the underlying goes back up but higher than the peak it just hit and with lower volume, again followed by a decline. The decline is stopped at or around the same price as the higher low created by the first price pop, resulting in another increase with even lower volume. The Head and Shoulders pattern is known as a reversal pattern. That is to say, if the Head and Shoulders forms with a higher head than left shoulder, the right shoulder would indicate a potential bearish turn upon completion.
The Psychology of Head and Shoulders
As I say a lot, if TA doesn’t tie back to the actual actions of human people in the market on some fundamental level, chances are great that it’s bullshit. So what are the basic market actions at play in the formation of this setup?
In the initial run-up you have price action being driven by volume. This can be catalyst-driven or can be driven by a number of other fundamental factors. The end result is that price turns bullish and its action is driven by market participants actively trading the underlying.
The head formation has comparatively very little volume, even on the sell-off side of the formation. Market participants who were gobbling up the stock are not buying and not selling enough for the price to be driven by volume. As a result you see the price rise in a somewhat inflated way because there are more buyers than sellers but very few of either. If 10 people want something only 5 people are willing to sell, you won’t have a lot of sales but the 10th person will be paying a hell of a lot more than they should by the end of it.
The last run up (the right shoulder) is more or less the same, but with lower volume-driven price action as market interest in the underlying wanes. The pattern finalizes as the “run” appears to be over, participants exit, and there are substantially more shares being sold than bought which leads to a precipitous reversal in the stock price.
What People Get Wrong
The number one thing that people seem to forget about Head and Shoulders is the volume component of the setup. If you have a pattern that looks like a Head and Shoulders on the price chart but where the volume isn’t correct, then you straight up do not have a pattern that is a Head and Shoulders.
So for example, let’s say you have a stock that looks like it’s forming a right shoulder to complete the setup.
This is the chart for $BF.A (Brown Forman’s Class A shares):
You can see the chart shares a bunch of the same cosmetic traits of a Head and Shoulder pattern if you don’t look at the volume. I wouldn’t even discount this setup as a Head and Shoulders if the volume was right despite breaking the neckline a bit there, your pattern finding needs to have tolerances for odd price action (news, etc) and the price recovered fast enough I would discount that. I wouldn’t hold it against you if you didn’t.
However, the real story here is in the volume. The price was buoyed by an increase in volume when the “head” was formed with a ton of volume on the sell-off side of the formation, which means this is likely more of a continuation pattern than a reversal pattern. You can see this was the case as the price did not reverse down toward the lower low, rather it rocket shipped off the neckline.
Summary
As with any chart setup, indicator, or anything else you use, nothing should be used on its own. Everything should be used in context and no one thing is a perfect indication of future price action.
When you decide that you want to trade on chart setups and patterns like this, it’s important that you’re taking the time to not just get a cursory understanding of the pattern. You have to make sure you’re getting the fullest view of the strategy possible. Otherwise you’re just playing make believe looking at charts and probably losing a lot of money in the process.
- - -
If you thought any of this was useful please make sure to subscribe to my Substack (link below) for lots of this type of content. I also do regular market commentary on my Twitter account (link below) so it's a good idea to follow that if you enjoy the kind of content I put out.