Head and shoulders (chart pattern)

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The head and shoulders pattern is a commonly found pattern in the price charts of financially traded assets (stocks, bonds, futures, etc). The pattern derives its name from the fact that its structure is visually similar to that of a head with two shoulders.

[edit] Structure of Head and Shoulders Pattern

Head and shoulders patterns have four elements: a left shoulder, which is essentially a relative peak; a head, which is a peak above both shoulders; a right shoulder, which is a peak that is approximately parallel to the left shoulder; and a neckline, which serves as a support, or bottom, of price activity within the range of the head and shoulders pattern. The chart below illustrates.

[edit] Interpretation

Traders often look to enter a position on the break of the neckline, interpreting the neckline as a support level. Upon a break of the neckline, traders will frequently set a target profit equal to the distance between the neckline and the head of the chart. A stop loss order is frequently set at where the right shoulder is. As a result, the head and shoulders pattern can be used by traders not only to identify entry points, but also to manage the risk of the trade as well.

The image below illustrates how a head and shoulders pattern can help traders identify entry points, stop-loss levels, and target profit levels.