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Heads and shoulders

Failure to reach the previous peak is another signal that the bears are becoming stronger.

, ET Bureau|
Jul 19, 2019, 09.55 AM IST
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As with other patterns, the rule here is simple – sell / go short when the head and shoulders’ neck line is broken.
DEFINITION: ‘Head and shoulder’ pattern occurs when the middle peak is significantly higher compared with the left and right peaks, which are at similar levels. Usually, the intervening bottoms also occur at the same level. The line connecting these two bottoms are called ‘neck line’ and sell signal is generated when prices go below this neck line.

HOW IT OCCURS: The first peak (left shoulder) and the higher middle peak (head) formation is normal in any bull market because it is usually characterised by higher peaks and bottoms. The first indication of a head and shoulder pattern is when the correction from the middle peak (head) comes all the way back to the previous bottom. In other words, one leg of the normal ‘bull market rule of higher top - higher bottom’ is broken here. The formation of two bottoms around the same price levels is a rare occurrence in a bull market and it shows that the bulls are becoming weaker. The neck line is also formed then. The right shoulder is formed when the bulls’ effort to salvage the situation by trying to push the prices to a new high, but fail. The failure to reach the previous peak (head) is another signal that the bears are becoming stronger. The critical moment is when the price comes back to the neck line, i.e. the price level which has received support in the past two attempts. The head and shoulders pattern is complete only when there is a neck line breakdown or the price falls below the neck line. Since any break below the neck line results in a continued price fall, it is considered bearish.

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INVERSE HEAD & SHOULDER: This is the mirror image of the head and shoulder pattern and is a bullish signal. It is defined as three bottoms with the middle bottom (head – marked as H in the chart) significantly lower than the other two bottoms (left and right shoulders – marked as LS and RS in the chart). Here again, the pattern is confirmed when the price breaks above the neck line.

TRADING RULES:
As with other patterns, the rule here is simple – sell / go short when the head and shoulders’ neck line is broken. As a precaution, stop loss is placed just above the neck line. And the rule for inverse head and shoulder is just opposite: buy / go long when the neck line is broken with stop loss just below the neck line.
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