Head and Shoulders

The head and shoulders pattern is one of the most commonplace features you will see in a stock. It consists of six trends in a stock that goes in opposite directions of one another. The stock’s value might change, but it will always go back to a pivot point. That point is formed at the start of the head and shoulders trend and will be the same at the very end. It is around the point where your strategy should come into play as you make a trade based on where the stock is about to move and how far it will go in that direction. When the head and shoulders pattern ends, the stock will break out. It will keep moving in one particular direction. There are two positions to see in the head and shoulders pattern:

Top Position

The head and shoulders top is the first position. This is a bearish pattern showing that the stock will fall in value giving traders the belief that the stock will keep declining.

There are six points in the head and shoulders top to see with each part of the pattern forming a distinct segment of the human body:

1. The left shoulder occurs when the value of a rising stock is about to decline in value or is stuck at the same total.
2. The first pullback occurs when the stock’s value drops and is then ready to go up.
3. The head is formed when the stock moves up and is then about to decline. The head should always be the highest point on the position.
4. The stock will move back to the value of the first pullback. This forms the second pullback.
5. The right shoulder is formed after the stock price moves up again and stays put for a bit before falling. The right shoulder can be higher or lower than the left shoulder.
6. The breakout occurs when the stock price goes below the pullback mark and keeps declining.

Trading the Top

A useful strategy for this head and shoulders top position layout is to place a short-trade around the breakout level. You can sell shares at the breakout level and then repurchase them not long after when the stock starts to decline. The value will keep on going back to or over the breakout point before the downward trend becomes more pronounced. You can also look at how quickly the value of the stock might start to decline. You might see cases where the stock’s value is steady but will experience slight declines every once in a while. You can use this when planning an options trade so you know when to place a put order.

Using the Price Target

A good strategy for a put option on the head and shoulders top is to place an order based on the price target that you have set up in this case. Here is what you can do to get this to work for you:

1. Take the right shoulder and subtract it from the breakout point.
2. You should have the height of the head and shoulders at this point.
3. Subtract the height from the breakout.
4. The result is the target you have for the decline in the value of the stock.

For example, a stock with a right shoulder of $35 and a breakout of $30 will have a height of $5. This should be subtracted from $30 to get to the $25 price target for a put option. This should be the mark that you want to get the stock down to when investing in this option.

You also have the option to play percentages when getting a price target set up:

1. Review the decline from the right shoulder to the breakout point.
2. Calculate the percentage of the decline. In the above example, the stock will have declined by about 15% as it goes from $35 to $30.
3. Set a target based on the percentage total below the breakout point. The target at this point would be 15% below $30. The target should be around $25.50.

You can use either option for setting the price point. The total will be close to the same regardless of what you choose.

Bottom Position

The bottom position is the next thing to calculate the measurement. The bottom head and shoulders setup is essentially the inverse of the top position:

1. The stock will be going down in value at the start.
2. The left shoulder forms around the end of a pattern where the value goes down.
3. The pullback positions occur when the stock moves back up in value.
4. The head will still be lower in value than anything else.
5. After moving back to the pullback position for the second time and then forming the right shoulder, the stock should move into the breakout point. At this juncture, the breakout point should be fully surpassed as the stock will begin to go up in value.

You can use the same target price measurement for the head and shoulders bottom as what you use for the top. You can use either the difference between the right shoulder and the breakout or the percentage difference between the two when calculating that price point.

The bottom setup is perfect for a call option. Watch how the stock responds while deciding on the proper target price.

Trading Ideas For Head and Shoulders

The most important strategy to use when trading the head and shoulders pattern is to wait for the pattern to complete itself before you enter into a position. You should never assume that the pattern will continue all the way. The earliest you could consider trading this pattern is to trade or start the option around the top part of the right shoulder. This is around the time when the trend for the stock should go in the direction you are expecting it to.

You can also wait for a few spots after the breakout point is reached to see where the stock moves. Look at how quickly it might take for the stock to move to a certain point and that it does not struggle in some way. You must be cautious when getting the head and shoulders pattern to work for you.