Head & Shoulders Pattern

Aside from trend channels, a range of well-known chart patterns exist that investors can trade. These are related to the physical shape of price movement (on a chart) and can be identified on a range of liquid shares. These patterns can come in both bullish (upward) and bearish (downward) forms. Below are some of the most common chart patterns (along with real examples) that you can look out for when investing in a share that can help you to predict future share price movement and hence restrict losses or help identify potential gains.

Head & Shoulders Formation

Head and shoulders formation
Bullish H&S for Standard Chartered shares
The head and shoulders (H&S) formation is an intermediate term pattern that can come in both a bullish and bearish form. The bullish form of the pattern is shown to the right. The formation is bullish when the shares are not trading near their peak and have actually fallen. The formation starts when a left shoulder is formed. This involves a spike down followed by a quick recovery spike that exceeds the starting price. This then falls back down to form the "inside of the arm". Following this, the share price recovers to form a high above the left shoulder. The price then falls back again to roughly the same level as before the head was created. These two troughs form the neckline.

The shares recover to roughly the same level as the top of the left shoulder before making one final drop down to around the base of the left shoulder. A line joining these two troughs is the shoulder base. Clearly this is a complex pattern so is not particularly common, but when it does appear it is very reliable. In the case of Standard Chartered, the buy signal exists when the shares move above the neckline following the H&S completion. A sensible stop loss would match the rising neckline. Trading on this basis would have seen a healthy gain in excess of 20%. A bearish H&S formation is when the pattern appears at the top of a trading cycle. In these instances, a sell signal is generated when the shares break below the neckline.


Inverse Head & Shoulders Formation

Bullish Inverse H&S for Lloyds shares
An inverse H&S formation (IH&S) is effectively just the H&S flipped upside down. The IH&S is usually a bullish pattern as it marks the reversal point for a trend. It is found near long/medium-term share price lows. A long-term example is shown for Lloyds shares between mid-2011 and late 2012. In this instance the neckline is slightly upward sloping whilst the top of the shoulders is downward sloping. The blue line illustrates the typical shape of the pattern. A buy signal was generated when the shares broke above the neckline in September. The shares have since rallied strongly amounting to well over a 50% increase.