As traders, we use technical analysis as a reliable method for speculating on future price direction of both equities (shares) and indexes. Technical analysis in simple terms is the study of historic price movements in a chart in search of patterns or consistently traded support and resistance levels. Today we are looking at a specific chart pattern that falls under “Reversal Patterns”, called the Head and Shoulders Pattern.
A Head and Shoulders is comprised of:
- Bullish movement to a resistance level creating the first (Left) Shoulder.
- The subsequent fall to a support level, creating what is known as the ‘Neckline’.
- The bullish rise after hitting the Neckline with the share price breaking through the Left Shoulder resistance level and creating a higher resistance level – this is called the Head.
- The fall back to the Neckline, then a rise back to roughly the ‘Left Shoulder’ resistance level where it reverses once again.
- The final part of the Head and Shoulders is the break of the Neckline, and subsequently a reversal in the long-term trend.
The Head and Shoulders can be a very reliable reversal pattern. You can see that after the share price has risen to create two resistance levels, it eventually falls through the neckline and then confirms the reversal in the trend, and then a bearish move lower. Often, it can be the beginning of a downtrend and is often more reliable when it occurs after a strong rise. Often it is considered a longer-term reversal pattern rather than a short term one.
Important Note: The Head and Shoulders is not confirmed until the Neckline has been broken.
Example: BlueScope Steel Limited (BSL)
In this example, you can see BSL has been in a downtrend since August of the prior year, with the stock more recently rallying slightly before forming the head and shoulders pattern. With the neckline being broken at the start of May, the stock has moved sideways since, but then falls once more. The share price has found a little bit of support at the $13.12 level, but if it were to break, a fall to $11.70 afterwards becomes more likely. A bearish strategy would be considered to profit from this expected move.
After this point in time, the stock ended up falling consistently before bottoming out around the $10.30 level.
There are many ways that you could take advantage of these patterns. As a specialist in derivatives, we can use tools to profit on a stock when it falls as well as when it rises, or even when it goes sideways.
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