Stock Pattern Interpretation: Master the trading logic of Head and Shoulders Top and Head and Shoulders Bottom

Market Psychology and Pattern Evolution

Technical Morphology reflects the psychological changes of market participants at different price levels. Head and Shoulders Top and Head and Shoulders Bottom are two classic reversal patterns, representing turning points in bullish and bearish forces respectively. These patterns recur because market participant behaviors are astonishingly similar throughout history.

Head and Shoulders Top: Three Stages from Peak to Decline

Left Shoulder — First Wave of Profit Taking

After the stock price hits a new high, early investors begin to realize gains. Although trading volume increases, this stage has already planted the seeds of decline. Some investors expect even higher prices and continue buying, causing a slight pullback after selling pressure emerges. The low point of this pullback is called the ** neckline**, which will later serve as a key support and resistance turn point.

Head — Signal of Exhausted Volume

After a round of turnover, new buyers continue to push the price higher, but as the height increases, trading volume diminishes — a warning sign. When selling pressure begins to outweigh buying, the head is formed and the reversal starts. This reversal is often accompanied by a significant decrease in volume, reflecting a breakdown of market consensus.

Right Shoulder — Evidence Confirming the Start of Decline

After the price falls back near the neckline, some cost-buyers attempt to break even, causing a second rebound. If this rebound’s high cannot surpass the previous high, it confirms the formation of the right shoulder. Once the price falls below the neckline again, the original support turns into resistance, and investor sentiment shifts to fleeing. Any rebound at this point could become a panic exit point; missing this window often results in deeper subsequent declines.

Practical Exit Strategy for Head and Shoulders Top

First Signal: When the right shoulder is confirmed (i.e., rebound high does not surpass the previous high) and the price breaks below the neckline, consider exiting immediately, even if the current price is still some distance from the high.

Second Signal: If you miss the first wave, observe whether the subsequent rebound can retake the neckline. If it cannot break through, reassess whether to exit, as a new head and shoulders top pattern may be forming.

Taking Tencent stock as an example, the rebound started at the end of 2022, forming the head in January 2023, with the right shoulder in March, and breaking the neckline at around 360 yuan in April. Even though this was a decline from the high of 415 yuan, the nearly one-year subsequent stock performance proved that missing this exit signal came at a huge cost, with the stock eventually falling below 200 yuan. There was a rebound opportunity at the end of 2023, but policy changes caused it to collapse, further confirming the risk of pattern invalidation.

Short Selling Framework in Head and Shoulders Top

For active short sellers, the head and shoulders top provides clear entry and exit points. The three key points are:

Entry Point: When the right shoulder is confirmed and the price breaks below the neckline.

Exit Point: When the price rises again and re-breaks the neckline, close the position immediately — do not hold on, as this suggests a potential trend reversal.

Profit Target: This is a profit protection mechanism. Use the distance from the entry point to the previous high as a basis for setting the target. For example, if the high is 415 and the entry is 360, the difference is 55 points; set the profit target at 305 (360 - 55). Taking Tencent as an example, shorting at 360 with a target of 305 can be achieved in about a month. Holding longer for more profit is possible but may not justify the time cost.

Head and Shoulders Bottom: Confirmation of Bottom and Uptrend Initiation

The head and shoulders bottom is a mirror image reversal of the top, indicating weakening selling pressure and the influx of new buyers.

Left Shoulder — Last Rebound During Downtrend

Before forming the bottom, the market experiences multiple rebounds. Many try to buy the dip, but each time the price hits the neckline, it stalls, showing insufficient strength. Volume is large initially but gradually diminishes, indicating selling pressure is waning.

Head — Quiet Moment at the Lowest Point

When volume shrinks to its minimum, the stock hits its bottom. Both buyers and sellers are watching, and the price faces little resistance to upward movement. Small buy orders can cause significant price increases until reaching the neckline resistance. If the price breaks through smoothly, a V-shaped reversal occurs; if not, the pattern enters the right shoulder phase.

Right Shoulder — Confirmation of Bullish Signal

The low point of the right shoulder is higher than the previous wave, indicating that buy orders are entering to defend the bottom. These buyers expect greater upward potential. Increased buying reduces selling pressure, and upward momentum strengthens.

Buying Signals and Profit Target Setting in Head and Shoulders Bottom

Buy Signal 1: Consider buying after the right shoulder forms. The rising lows suggest higher highs, making this a relatively lower-risk entry point.

Buy Signal 2: Buy after the price breaks through the neckline. The upward trend is confirmed, increasing the probability of continued rise and easing market pressure.

These two signals have trade-offs: the first offers a lower entry price but higher risk; the second is safer but may miss the lowest price.

Calculation Method for Head and Shoulders Bottom Profit Target

After entering, set two defensive levels:

Stop Loss: If the price falls below the right shoulder, it indicates a new bottom may be forming, and a stop loss should be placed. Use the right shoulder for entries below the neckline; use the head for entries below the right shoulder.

Profit Target: Set based on the distance from the entry point to the head. For example, if the head is at 100 yuan and the entry is at 120 yuan, the difference is 20 yuan. The target should be at the neckline plus 20 yuan. For short-term traders, it is recommended to set the profit target at 2-3 times the stop loss distance, so even with a 30% success rate, the average remains profitable.

Failure Scenarios of Patterns in Practice

Fundamental Changes Directly Invalidating the Pattern

The effectiveness of technical patterns relies on relatively stable fundamentals. When major news occurs, patterns can instantly invalidate. At the end of 2023, Tencent was completing a bottoming process, with the right shoulder forming in early December, but a policy crackdown caused a 12.3% plunge at the end of the month, completely destroying the pattern.

Low Volume Assets Not Suitable for Morphology Analysis

Patterns are based on statistical samples; the more abundant the samples, the more reliable the pattern. Assets with low trading volume often do not follow patterns, and the validity of patterns in large stocks and indices is much higher than in small-cap stocks.

Summary

Head and Shoulders Top and Bottom provide statistical decision-making references but are not foolproof predictive tools. The key is understanding the market psychology behind the patterns and making correct judgments at critical points like the neckline, left shoulder, head, and right shoulder. Whether seeking exit points in a top or setting profit targets in a bottom, it is essential to combine fundamental analysis, volume, and other factors for validation. Morphology is an auxiliary tool; markets are always variable. Staying alert and flexible is the foundation for long-term profits.