Recently, I’ve been pondering a question. When many people look at stock charts, they often hear the terms "Head and Shoulders Top" and "Head and Shoulders Bottom," but few truly understand them. I myself spent quite some time figuring them out, and today I want to share my observations over the years.

Let’s start with the Head and Shoulders Top. Simply put, a Head and Shoulders Top is formed when the stock price creates three peaks—left shoulder, head, and right shoulder. When this pattern appears, it usually indicates that the stock price is about to decline. But why is that? I think the key lies in changes in trading psychology.

The first wave of the stock price surges (left shoulder), and some investors start taking profits, while others remain optimistic about the future and continue buying. At this point, trading volume increases. The stock price then slightly pulls back to the so-called "neckline," which is very important as a support level. Because buying interest still exists, the price continues to rise, forming the head. But at this stage, trading volume actually decreases because everyone wants to sell at the high point. As a result, selling pressure exceeds buying, and the head reverses.

Next is the formation of the right shoulder. The stock price falls back to the neckline again, and another wave of buyers enters—most of them are those who bought at the neckline earlier, aiming to average down. The price may rebound, but if this rally cannot surpass the previous high, the right shoulder is officially formed. At this critical moment, if the price breaks below the neckline, the original support turns into resistance, and investor sentiment shifts completely, with many thinking about escaping.

I’ve seen Tencent as an example. It started rebounding at the end of 2022, formed the head in January 2023, and the right shoulder in March. When it broke the neckline in April at around 360 yuan, if you sold then, although it was still below the high of 415, the stock price nearly a year later never exceeded 360 and is now only in the 200s. Missing that escape point resulted in a significant cost later.

If you want to profit from shorting using the Head and Shoulders Top, I recommend setting three key points: entry point, exit point, and satisfaction point. The entry point is when the price breaks below the neckline. The exit point must be closely watched at the neckline because if the price rebounds and breaks above it, you should close your short position immediately. The satisfaction point can be calculated based on the distance from the entry point to the head. In Tencent’s case, entry at 360, with a 55-point difference from the head to the entry, sets the satisfaction point at 305. It only took a month to reach that point. Holding on longer would only earn an extra 19 yuan over half a year, which isn’t worth the time.

Now, let’s talk about the Head and Shoulders Bottom, which is the opposite scenario. It signals a bullish trend. You can think of the head and neckline pattern inverted. This pattern indicates weakening selling pressure and the emergence of new buyers.

The left shoulder is the last rebound before the bottom forms. During the decline, there are multiple rebounds, but no one can predict the exact bottom in advance. As more stop-losses are triggered, more investors start to buy the dip, causing the price to rebound. If the rebound reaches the neckline but cannot break through, it indicates insufficient momentum. Initially, trading volume is relatively large, but as fewer dip-buyers remain, selling pressure diminishes. When volume shrinks to its minimum, that’s the head of the Head and Shoulders Bottom—the lowest point.

At the head, trading volume is very small because sellers have mostly sold out, and buyers are not in a rush. At this point, the rebound has almost no resistance, and small buy orders can push the price higher. If the price can directly break through the neckline, it’s a V-shaped reversal.

The appearance of the right shoulder signals that an upward trend is imminent. The low point of the stock is higher than the previous one, indicating buy orders are supporting the price—these buyers likely believe the rally will continue or are taking profits on short positions. Either way, these buy orders reduce selling pressure and increase upward momentum. Once the price breaks through the neckline resistance, that resistance turns into support.

Regarding buy signals for the Head and Shoulders Bottom, I think there are two good timing options. First, buy immediately after the right shoulder is confirmed, because the gradually rising lows suggest higher highs, aligning with an uptrend. Second, buy after the price breaks through the neckline, as this confirms the trend and involves less risk.

The advantage of the first signal is a cheaper entry price, but it carries higher risk. The second signal has lower risk but might miss the lowest price. It depends on your trading style.

When setting stop-loss points, if you enter at the neckline, you can use the right shoulder’s low as your stop-loss. For profit targets, short-term traders can set a stop-loss at 2 to 3 times the distance from the entry to the head. This way, even with a win rate of only 30%, you can still be profitable on average.

However, I must emphasize that technical patterns are only references and cannot guarantee 100% profits. In actual trading, low-probability events can occur. For example, a sudden fundamental change can invalidate the pattern. In Tencent’s case, it was expected to rebound at the end of 2023, but the government suddenly introduced policies to crack down on online gaming, causing a 12.3% plunge in a single day, directly destroying the pattern.

Additionally, assets with very low trading volume are not suitable for pattern analysis. Patterns are based on statistical data, and the larger the sample size, the more accurate the results. Therefore, large-cap stocks are more suitable than small-cap stocks, and indices are more suitable than individual stocks.

In summary, patterns like Head and Shoulders Top and Bottom are just statistical tools. When these situations occur, there’s a high probability of specific price movements. They can be used as references but shouldn’t be blindly followed. Ultimately, combining technical analysis with fundamentals and other factors is essential to truly improve trading success.