Head and Shoulders

A Head and Shoulders pattern is a specific chart formation used in technical analysis that supposedly predicts a reversal in a stock's price trend from bullish (upward) to bearish (downward). Imagine a simple skyline silhouette: it consists of three peaks, with the middle peak (the “head”) being the highest, and the two outside peaks (the “shoulders”) being lower and roughly equal in height. These three peaks are connected by their troughs, and a line drawn to connect these troughs forms what's known as the neckline. For technical traders, this pattern is like a warning siren. The story it tells is one of fading momentum. The initial rally forms the left shoulder, but the subsequent push higher to form the head fails to hold, and the final rally to form the right shoulder is even weaker, showing that buyers are exhausted. When the stock price finally falls below the neckline, traders who follow this method see it as a confirmation to sell, believing a significant downturn is imminent.

Spotting this pattern requires a bit of imagination, as real-world charts are rarely as perfect as textbook examples. However, the core components are always the same.

This pattern signals a potential market top and a subsequent decline.

1. The Left Shoulder: The stock price rises to a peak and then falls back.
2. The Head: The price rallies again, pushing to an even higher peak than the left shoulder, before declining again to roughly the same level as the previous trough.
3. The Right Shoulder: A third rally occurs, but it's weaker and fails to reach the height of the head, peaking at a level similar to the left shoulder.
4. The Neckline: This is the crucial support line connecting the low points of the two troughs between the shoulders and the head. The pattern is considered “confirmed” only when the price breaks decisively below this neckline.

There is also a bullish version of this pattern, which is essentially the classic pattern flipped upside down. It signals a potential market bottom and a reversal from a downtrend to an uptrend. It consists of three troughs, with the middle one (the head) being the lowest. A break above the neckline here is considered a buy signal by technical traders.

At its heart, the Head and Shoulders pattern is a story about the shifting balance between buyers and sellers. The formation of the head represents the peak of buying enthusiasm. The failure of the right shoulder to reach that same height suggests the buyers are running out of steam. Sellers are beginning to take control, and when the price breaks the neckline—a level of support where buyers had previously stepped in—it’s seen as the final capitulation. For a technical trader, this is the moment of truth. They might use this signal to:

• Sell a long position or initiate a short sale.
• Set a price target for the decline, often estimated by measuring the distance from the head to the neckline and projecting that same distance downward from the breakout point.
• Place a stop-loss order just above the neckline to manage risk if the signal turns out to be false.

Now, let's put on our value investing hat. What do legendary investors like Benjamin Graham or Warren Buffett think about patterns like these? In short: not much. From a value investor's standpoint, relying on chart patterns is like trying to drive a car by looking only in the rearview mirror. It's a form of speculation, not investing. Investing is about determining a company's intrinsic value based on its business fundamentals—its earnings power, assets, debt, and management quality. You buy a stock because you believe the business is worth significantly more than its current market price, creating a margin of safety. The decision to buy or sell has nothing to do with squiggly lines on a chart. A true value investor is a business analyst, not a chart reader. They ask questions like:

• Is this a durable, profitable business?
• Is it run by honest and competent managers?
• Can I buy it at a reasonable price?

The Head and Shoulders pattern focuses solely on price and momentum, completely ignoring the “value” part of the equation. While a sharp price drop (which the pattern might signal) could be a catalyst for a value investor to take a closer look at a company—perhaps the market is panicking and offering a bargain—the pattern itself is irrelevant to the final investment decision. The focus remains on the business, not its chart's silhouette.