The head and shoulders pattern has a very memorable name and gives a striking look. However, the head and shoulders pattern is more than a beautiful chart. It gives real value to traders.
It’s an easy to spot pattern because of its three peaks, with the middle one being the highest.
You must have read that the head and shoulders pattern is formed when the market is about to reverse lower. So, anytime you spot this pattern, you short the market.
Doing this is risky ! In case the market keeps on going higher, you will get stopped out. This means there is more than what your eyes see. You MUST not always short the market when you spot this pattern.
This article will guide you through the head and shoulders pattern trading strategy. It is tailored for both beginners and experienced traders.
The article will help you avoid the mistakes most traders make, whose result is losing money.
In this article, you will learn:
Let’s get started…
What is the Head and Shoulders Pattern?
It is a price reversal chart pattern that helps traders know when a reversal may occur after a trend exhausts itself. It signals the end of an uptrend.
This pattern can appear at any timeframe, hence, it can be used by all types of investors and traders.
Its entry levels, price targets and stop levels makes the pattern easy to implement since the chart pattern provides important levels that are easy to see.
The Psychology Behind Head and Shoulders Pattern
In a triangle pattern, bulls/buyers and bears/sellers are fighting, with each side trying to gain control.
Breakouts usually occur in the winning direction. The goal of bulls is to achieve higher highs and lower lows, while the goal of bears is to achieve lower highs and lower lows.
As this fight intensifies, volume will decrease and uncertainty will increase, as the price range begins to narrow.
So, both bulls and bears decide to wait on the sidelines for the direction to become clear before they can jump in again.
That is why after a breakout occurs, volume and price tends to rise, since all buyers and sellers waiting on sidelines begin to make their move.
How to Spot the Head and Shoulders Pattern
The head and shoulders pattern is characterized by a peak (shoulder), which is followed by a higher peak (head) and then a lower peak (shoulder).
A line is then drawn to join the lowest points of the two formed troughs. This line becomes the neckline. The neckline can slope upwards or downwards.
Below is what I am describing.
Let us discuss the above events in their order of occurrence:
#1: Uptrend
-This is the first part of the head and shoulders pattern.
-It is the extended move higher that causes exhaustion.
-A longer uptrend results into a more substantial reversal.
#2: Left Shoulder
–A pullback occurs in the market, moving down to create a higher low.
-At this point, you cannot tell whether the market will reverse since a pullback is a regular occurrence in a trending market.
-It should be the highest point of the current bull trend at its formation point.
-It can simply be interpreted as a price rise, followed by price peak, then a price decline.
#3: Head
-The price rises again creating a higher peak.
-It should be higher than the left shoulder.
-At this point, the market is trading above its previous high.
-The sellers gain control and push the price lower towards the previous swing low.
-That is how the neckline was formed.
-However, we still need the right should to draw the neckline on our chart.
#4: Right Shoulder
-It indicates that the buyers are getting tired and the market is geared towards a reversal.
-A decline occurs again, then rises to form the right peak, which is lower than the head.
-The buyers made their final attempt to push the price higher, but it could not even break above the head.
-The sellers gained control and pushed the price towards the neckline.
#5: Neckline
-Now that the head and the two shoulders have been formed, we can draw the neckline support.
-This line connects the valleys formed by the price swing.
-It forms the last line of defense for buyers.
-If the price breaks below the neckline, the market may head lower, marking the beginning of a downtrend.
-If the prices rises above the head before it breaks the neckline, the pattern will become invalid.
Inverse Head and Shoulders
This is a head and shoulders pattern only that it’s upside down. It consists of a valley (shoulder), followed by a lower valley (head) and then another valley (shoulder). The pattern is formed after extended downward movements.
The inverse head and shoulder pattern signals the possibility of a trend reversal since the sellers are not capable of pushing the price lower.
It begins with a downtrend. This is an extended move down that leads to an exhaustion and a reversal higher.
This comes as buyers step up and sellers exit. The downtrend is met by a minor support, forming the left shoulder.
As the market starts to move higher, it encounters a strong resistance and bounces off, and the downtrend resumes. This resistance level creates the neckline.
After the market has made a lower low, it gets a strong support, forming the head of the pattern. The market encounters resistance at the neckline again, and the right shoulder is formed.
At this point, the pattern is beginning to take shape, but it isn’t yet confirmed until the market closes above the neckline resistance.
Most traders don’t recognize this, hence, they may mistakes. The pattern is only confirmed when the market closes above the neckline resistance.
From the above figure, the market is trading above the neckline. The break and close confirm an inverse header and shoulders pattern and it signals a breakout opportunity.
What Causes the Head and Shoulders Pattern to Form?
Each price action carries a message. Some messages are easier to read compared to others.
The head and shoulders pattern is a signal that the buyers are getting tired and you should prepare yourself for a reversal.
But how can a few swing highs cause a market to reverse?
Most traders think that it’s the price structure that causes the market to reverse, which is wrong.
The market reversal is caused by transition between buyers and sellers. The head and shoulders pattern is just a byproduct of this process.
The head and shoulders reversal works because of the interaction between the highs and the lows at the top of an uptrend.
Head and Shoulders Breakout
Most traders conclude that the pattern is complete once it forms the right shoulder. This is a common mistake by forex traders.
The pattern is only complete once the market closes below the neckline. This is the only time you should trade.
The head and shoulders pattern is only confirmed once it breaks the neckline support, that is, it closes below the neckline.
In the above figure, the market closes below the neckline. This means that the head and shoulders pattern has been confirmed. It also signals a breakout.
Let me give you a tip! On a daily chart, it will be wise for you to wait for a daily close below the neckline before you can consider making an entry.
How to Trade the Pattern
Now that you know more about the head and shoulders pattern, how can you trade it?
Entry Methods
As a trader, it will be good to wait for the pattern to complete. The reason is that the pattern may fail to complete or it may take long to complete.
Partial and nearly completed patterns should be watched, and no trade should be placed until the pattern breaks the neckline.
In the head and shoulder pattern, you should wait for the price action to move below the neckline once it has reached the peak of the right shoulder.
For the case of inverse head and shoulder pattern, you should wait for the price action to move above the neckline once the right shoulder has been formed.
You can initiate a trade once the pattern has completed. However, it will be good if you plan the trade beforehand.
You simply have to write down the entry, stops and profit targets. Also, write down any variables that may change your stop and profit target.
The most entry point for the head and shoulders pattern is after the occurrence of a breakout.
There is also another entry technique that requires you to be more patient. However, it is a risky technique as the move may be missed altogether.
You simply wait for a pullback to the neckline once a breakout has occurred. It is a more conservative approach as you can see whether the pullback stops and whether the original breakout direction resumes.
If the price keeps on moving towards the direction of the breakout, the trade may be missed.
Stop Loss Placement
This is a controversial topic among traders. Some traders choose to place a stop above the right shoulder. Other traders choose an aggressive placement.
I believe that placing the stop loss above the right shoulder can be excessive. It’s not necessary and it has an impact on your risk to reward ratio.
Here is the reason…
The head and shoulders pattern is confirmed with a close that comes below the neckline. What does it mean? A close above the neckline will negate this pattern.
Now, if I place my stop above the right shoulder, will I wait for the market to take me out in case it closes above the neckline?
Certainly not.
Luckily, you have two ways to exit the trade if things don’t work for you. Let’ discuss these….
#1 Stop Loss Placement
You can choose to place your stop loss just above the right shoulder.
This option will provide you with enough space between your entry and stop loss.
However, it’s not a good thing. I believe that it will do you more harm than good. Such a high stop loss means that you will have cut your profit by half or even more.
Let’s consider another option, probably a better one.
#2: Stop Loss Placement
This is a better stop loss placement, giving you a better risk to reward ratio and the ability to hide your “stop”.
The stop has been placed above the last swing. Avoiding placing it far from your entry point so that it doesn’t impact your potential reward.
However, go as tighter as you want, provided it fits your trading style. Always keep in mind that if you keep your stop loss closer to your entry point, you increase your chances of being taken out of the trade prematurely.
Head and Shoulders Target
Knowing when to take profit can mark the difference between winning a trade and losing a trade. It’s one of the most challenging aspects of trading.
With the head and shoulders pattern, you can any of the following approaches to this…
#1: Approach
The most conservative approach is to book the profit when you reach the first key support level.
The key support levels are the areas that you have defined and can make the market to bounce. It will be a good idea for you to take profit after a retest of any of the areas.
Different situations have different impacts, meaning that the support levels will vary. However, doing this will give you a good risk to reward ratio. So, always do the math before you can take the trade.
#2: Approach
Secondly, you can use a measured objective. It’s a more aggressive approach since the target is located away from the entry. Despite this, it’s a universal approach. Why?
With this approach, you determine the measurement of the whole pattern. This means regardless of what is happening in the market, you will always have a certain target area. The following chart demonstrates this:
Notice that I have measured right from the top of the head directly to the neckline. A similar amount of distance has then been measured lower from the breakout point.
Although measured objects tend to be more accurate, they can’t be perfect. However, use them to validate the target area and you will get a greater degree of confidence when trading.
Conclusion
This is what you’ve learned…
-The head and shoulders pattern can occur in all time frames
-It’s a subjective pattern, but its complete pattern provides entries, stops and profit targets. From this, you can come up with a trading strategy.
-The pattern is made up of a left shoulder, a head and then a right shoulder.
-The most popular entry point is a breakout of the neckline, with the stop being above or below the right shoulder.
-The profit target is calculated as the difference between the high and the low with the pattern being subtracted or added from the breakout price.