A Talkative Technical Signal Seen from Tencent's Head and Shoulders Drop

Have you ever thought that investors who bought Tencent at a high of 415 yuan in 2023 and only escaped at 360 yuan actually had the opportunity to exit safely much earlier? The key lies in a technical pattern called Head and Shoulders.

Tencent’s story is a textbook example of the Head and Shoulders pattern: rebound at the end of 2022 → formation of the left shoulder in November → reaching the head at the end of January 2023 → appearance of the right shoulder in March. When the stock price broke below the neckline (support level) in April, savvy investors had already exited with gains. Over the following year, the price never surpassed 360, eventually forcing many to cut losses at around 200 yuan.

Why did this happen? Because the Head and Shoulders and Inverse Head and Shoulders patterns are actually telling us: market psychology is shifting.

Hidden Market Signals in the Head and Shoulders Pattern

The Head and Shoulders pattern is about three relative peaks—the left shoulder, the head, and the right shoulder. Simply put, the price surges, some take profits, new buyers enter, it pushes up again but fails to reach a new high, and finally a third shoulder forms.

Let’s break down the process:

When the left shoulder appears, the first wave of buying comes in, volume increases, some sell, others buy in. The price dips slightly to a low point—that’s the neckline, which also acts as the first support level.

When the head forms, new buyers believe the rally will continue, pushing the price higher. But as it goes up, buying momentum weakens (since everyone wants to sell at the top). Eventually, selling exceeds buying, and the price reverses. This turning point is the head.

The right shoulder is the real warning sign. The price rebounds again, but this time it cannot surpass the previous head. Those who didn’t sell at the high are now stuck near their cost basis. They don’t want to realize losses, so when the price returns to their cost, they start to sell. This rebound’s energy is limited, which is normal.

At this point, the neckline shifts from support to resistance. Once the price breaks below it, market sentiment flips—every rebound could become a “get out now” opportunity.

How to Decide When to Exit

There are two signals worth paying attention to:

First, when the right shoulder forms and the price breaks below the neckline, consider selling immediately. This is the clearest exit signal.

Second, if you miss the initial exit, observe the second rebound. If the price rebounds above the neckline again, reassess whether a new pattern is forming. Without confirmation of a new pattern, it’s safer to sell on the rebound.

For short-selling, the entry point is when the price breaks below the neckline. Exit should be closely monitored—if the price rises back above the neckline, close the position immediately, regardless of profit or loss, since the downward trend is invalidated.

It’s also advisable to set a “profit target.” Calculate the distance from the entry point to the head; this equals the expected profit. For example, if you shorted at 360 and the head is at 415, the 55-point difference is your target, so you might exit at around 305. Tencent was like this—entered in April and hit the target by May, without waiting for a lower price.

Conversely: Inverse Head and Shoulders as a Buying Opportunity

If the Head and Shoulders pattern signals a decline, the Inverse Head and Shoulders pattern indicates a potential rise. Imagine flipping the Head and Shoulders upside down—that’s what an inverse pattern looks like, signaling weakening selling pressure and new buying.

The left shoulder in the inverse pattern is the last rebound during a downtrend. Many want to buy the dip, but no one truly knows where the bottom is. As stop-loss orders increase and more buyers step in, the price begins to rebound. If this rebound fails to surpass the previous high, volume gradually diminishes until the lowest point appears—that’s the head.

At the head, sellers have mostly exited, and buyers lack urgency. Small buy orders can then push the price sharply higher. Breaking through the neckline resistance is a classic V-shaped reversal. If the first attempt fails, a right shoulder forms.

When the right shoulder appears, its low point is higher than the previous one, indicating buy orders are supporting the price. These buyers are optimistic about the future or are short-sellers taking profits. Either way, selling pressure decreases, and upward momentum increases. Once the price breaks above the neckline, the line shifts from resistance to support—many who bought at this level will continue to buy as the price returns.

Two Buy Signals

The first is to buy immediately after the right shoulder is confirmed. Following the principle “lower than the previous low, higher than the previous high,” the lows are rising and highs are also rising, confirming an uptrend. Entering at this point offers a relatively low price with high potential reward, though risk is higher.

The second is to buy after the price breaks above the neckline. At this stage, the uptrend is confirmed, and market pressure is lighter, so risk is lower. The downside is you might miss the absolute bottom.

Setting Stop-Loss and Take-Profit

If entering at the neckline, set the stop-loss at the right shoulder’s low. If the price falls below this, it may indicate a new bottom. Conversely, if entering at the right shoulder, the head’s price can serve as the stop-loss.

Profit targets vary per trader. Short-term traders often set take-profit at 2-3 times the stop-loss distance, so even with a win rate of only 30%, they can still be profitable on average.

When the Pattern Fails

Technical patterns are just tools to improve win probability; they cannot guarantee profits 100%. Two common “breakdowns” are:

Fundamental changes. The effectiveness of patterns relies on stable fundamentals. For example, Tencent was preparing for a rebound in late 2023, but in December, news broke of government crackdowns on online gaming, causing a sudden 12.3% drop in one day, instantly destroying the pattern. Major events like this can invalidate technical analysis.

Low trading volume stocks. Patterns are statistical; the more data points, the more reliable. Stocks with very low trading activity won’t follow chart patterns well. Generally, larger-cap stocks and indices are more suitable than small caps.

Final Reminders

Both Head and Shoulders and Inverse Head and Shoulders are only reference indicators, showing high-probability scenarios based on statistics. They do not guarantee specific outcomes.

Also, pay attention to these practical details: the left and right shoulders don’t need to be exactly equal in height—just the right shoulder should be lower than the head; the neckline doesn’t have to be perfectly horizontal—it can be sloped, serving as a relative support or resistance line.

Combining other analysis methods, fundamental research, and market environment judgment is essential to truly improve trading success.