What Is the Head and Shoulders Pattern?

A head and shoulders pattern is used in technical analysis. It is a specific chart formation that predicts a bullish-to-bearish trend reversal. The pattern appears as a baseline with three peaks, where the outside two are close in height, and the middle is highest.

The head and shoulders pattern forms when a stock’s price rises to a peak and then declines back to the base of the prior up-move. Then, the price rises above the previous peak to form the “head” and then declines back to the original base. Finally, the stock price peaks again at about the level of the first peak of the formation before falling back down.

The head and shoulders pattern is considered one of the most reliable trend reversal patterns. It is one of several top patterns that signal, with varying degrees of accuracy, that an upward trend is nearing its end.

Understanding the Head and Shoulders Pattern

A head and shoulders pattern has four components:

1. After long bullish trends, the price rises to a peak and subsequently declines to form a trough.
2. The price rises again to form a second high substantially above the initial peak and declines again.
3. The price rises a third time, but only to the first peak level, before declining again.
4. The neckline, drawn at the two troughs or peaks (inverse).

The first and third peaks are the shoulders, and the second peak forms the head. The line connecting the first and second troughs is called the neckline.

Inverse Head and Shoulders

The opposite of a head and shoulders chart is the inverse head and shoulders, also called a head and shoulders bottom. It is inverted with the head and shoulders bottoms used to predict reversals in downtrends. This pattern is identified when the price action of a security meets the following characteristics:

• The price falls to a trough, then rises
• The price falls below the former trough, then rises again
• The price falls again but not as far as the second trough
• Once the final trough is made, the price heads upward toward the resistance (the neckline) found near the top of the previous troughs.

Of these, the second trough is the lowest (the head), and the first and third are slightly shallower (the shoulders). The final rally after the third dip signals that the bearish trend has reversed, and prices are likely to keep rallying upward.

What Does the Head and Shoulders Pattern Tell You?

The head and shoulders pattern indicates that a reversal is possible. Traders believe that three sets of peaks and troughs, with a larger peak in the middle, means a stock’s price will begin falling. The neckline represents the point at which bearish traders start selling.

The pattern also indicates that the new downward trend will likely continue until the right shoulder is broken—where prices move higher than the prices at the right peak.

Advantages and Disadvantages of the Head and Shoulders Pattern

Advantages Explained

• Experienced traders identify it easily: The pattern is very recognizable to an experienced trader.
• Defined profit and risk: Short and long entry levels and stop distance can be clearly defined with confirmation openings and closings.
• Big market movements can be profited from: The timeframe for a head and shoulders pattern is fairly long, so a market can move significantly from entry to close price.
• Can be used in all markets: The pattern can be used in forex and stock trading.

Disadvantages Explained

• Novice traders might miss it: The head and shoulders pattern may not present with a flat neckline; it may be skewed, which can throw off new traders.
• Large stop loss distances possible: Large downward movement over long timeframes can result in a large stop distance.
• Neckline can appear to move: If the price pulls back, the neckline might be retested, confusing some traders.

The Bottom Line

The head and shoulders is a pattern used by traders to identify price reversals. A bearish head and shouders has three peaks, with the middle one reaching higher than the other two. It indicates a reversal of an upward trend.

A bullish head and shoulders has three troughs, with the middle one reaching lower than the other two. It indicates a reversal of a downward trend.

What Are Fibonacci Retracement Levels?

Fibonacci retracement levels—stemming from the Fibonacci sequence—are horizontal lines that indicate where support and resistance are likely to occur.

Each level is associated with a percentage. The percentage is how much of a prior move the price has retraced. The Fibonacci retracement levels are 23.6%, 38.2%, 61.8%, and 78.6%. While not officially a Fibonacci ratio, 50% is also used.

The indicator is useful because it can be drawn between any two significant price points, such as a high and a low. The indicator will then create the levels between those two points.

Suppose the price of a stock rises $10 and then drops $2.36. In that case, it has retraced 23.6%, which is a Fibonacci number. Fibonacci numbers are found throughout nature. Therefore, many traders believe that these numbers also have relevance in financial markets.

Fibonacci retracement levels were named after Italian mathematician Leonardo Pisano Bigollo, who was famously known as Leonardo Fibonacci.  However, Fibonacci did not create the Fibonacci sequence. Instead, Fibonacci introduced these numbers to western Europe after learning about them from Indian merchants. Fibonacci retracement levels were formulated in ancient India between 450 and 200 BCE.

Numbers First Formulated in Ancient India

Despite its name, the Fibonacci sequence was not developed by its namesake. Instead, centuries before Leonardo Fibonacci shared it with western Europe, it was developed and used by Indian mathematicians.

Most notably, Indian mathematician Acarya Virahanka is known to have developed Fibonacci numbers and the method of their sequencing around 600 A.D. Following Virahanka’s discovery, other subsequent generations of Indian mathematicians—Gopala, Hemacandra, and Narayana Pandita—referenced the numbers and method. Pandita expanded its use by drawing a correlation between the Fibonacci numbers and multinomial co-efficients.

It is estimated that Fibonacci numbers existed in Indian society as early as 200 B.C.

The Formula for Fibonacci Retracement Levels

Fibonacci retracement levels do not have formulas. When these indicators are applied to a chart, the user chooses two points. Once those two points are chosen, the lines are drawn at percentages of that move.

Suppose the price rises from $10 to $15, and these two price levels are the points used to draw the retracement indicator. Then, the 23.6% level will be at $13.82 ($15 – ($5 × 0.236) = $13.82). The 50% level will be at $12.50 ($15 – ($5 × 0.5) = $12.50).

How to Calculate Fibonacci Retracement Levels

As discussed above, there is nothing to calculate when it comes to Fibonacci retracement levels. They are simply percentages of whatever price range is chosen.

However, the origin of the Fibonacci numbers is fascinating. They are based on something called the Golden Ratio. Start a sequence of numbers with zero and one. Then, keep adding the prior two numbers to get a number string like this:

• 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987…with the string continuing indefinitely.

The Fibonacci retracement levels are all derived from this number string. After the sequence gets going, dividing one number by the next number yields 0.618, or 61.8%. Divide a number by the second number to its right, and the result is 0.382 or 38.2%. All the ratios, except for 50% (since it is not an official Fibonacci number), are based on some mathematical calculation involving this number string.

Interestingly, the Golden Ratio of 0.618 or 1.618 is found in sunflowers, galaxy formations, shells, historical artifacts, and architecture.

What Do Fibonacci Retracement Levels Tell You?

Fibonacci retracements can be used to place entry orders, determine stop-loss levels, or set price targets. For example, a trader may see a stock moving higher. After a move up, it retraces to the 61.8% level. Then, it starts to go up again. Since the bounce occurred at a Fibonacci level during an uptrend, the trader decides to buy. The trader might set a stop loss at the 61.8% level, as a return below that level could indicate that the rally has failed.

Fibonacci levels also arise in other ways within technical analysis. For example, they are prevalent in Gartley patterns and Elliott Wave theory. After a significant price movement up or down, these forms of technical analysis find that reversals tend to occur close to certain Fibonacci levels.

Fibonacci retracement levels are static, unlike moving averages. The static nature of the price levels allows for quick and easy identification. That helps traders and investors to anticipate and react prudently when the price levels are tested. These levels are inflection points where some type of price action is expected, either a reversal or a break.

Fibonacci Retracements vs. Fibonacci Extensions

While Fibonacci retracements apply percentages to a pullback, Fibonacci extensions apply percentages to a move in the trending direction. For example, a stock goes from $5 to $10, then back to $7.50. The move from $10 to $7.50 is a retracement. If the price starts rallying again and goes to $16, that is an extension.

Limitations of Using Fibonacci Retracement Levels

While the retracement levels indicate where the price might find support or resistance, there are no assurances that the price will actually stop there. This is why other confirmation signals are often used, such as the price starting to bounce off the level.

The other argument against Fibonacci retracement levels is that there are so many of them that the price is likely to reverse near one of them quite often. The problem is that traders struggle to know which one will be useful at any particular time. When it doesn’t work out, it can always be claimed that the trader should have been looking at another Fibonacci retracement level instead.

The Bottom Line

Fibonacci retracements are useful tools that help traders identify support and resistance levels. With the information gathered, traders can place orders, identify stop-loss levels, and set price targets. Although Fibonacci retracements are useful, traders often use other indicators to make more accurate assessments of trends and make better trading decisions.