How to trade the Head and Shoulders chart pattern
This chart pattern is heavily used by traders to detect trading opportunities by identifying potential trend reversals
What is the Head and Shoulders pattern?
Traders usually apply the head and shoulders chart pattern in their technical analysis to identify potential trend reversals. Of course, you can use it for any time frame but it works better on longer time periods. Also, this pattern is applicable to different types of instruments.
There are two basic setups:
- The standard head and shoulders pattern. It is an indication of an upcoming downward trend
- An inverse pattern. It signals that the price will start moving upward.
The components of the Head and Shoulders chart pattern
A fully formed chart pattern is composed of four elements – left shoulder, head, right shoulder and the neckline. A complete head and shoulders formation is identified when the price breaks the neckline. Although the components are the same for the standard and inverse pattern, there is a difference in the direction of the elements between the bearish and bullish chart setup.
The bearish head and shoulders pattern is formed during an uptrend by a peak and a pullback (left shoulder) followed by a higher peak and retracement (the head) followed by a lower peak and downward price movement (right shoulder). The neckline is drawn at the bottoms reached by the price between the shoulders and head (from left to right). When the price breaks below the neckline level it means the trend reversal.
The bullish head and shoulders pattern will be identified in a downtrend when the price movements display a bottom and then retracement (left shoulder) followed by lower bottom and pullback (the head) and a higher bottom (right shoulder). The neckline is drawn as a straight line connecting the price tops between the shoulders and the heads. A bullish trend is expected when the price moves above the neckline.
The neckline is an important element of the pattern because it serves as a support level in anticipation of a bearish head and shoulders pattern. It is viewed as the resistance level when traders look for bullish head and shoulders. Traders wait for the price to break these levels before they execute their trades. Keep in mind though that depending on the instrument, the neckline can have a different slope within the pattern and you should be aware of the slope pattern for the instrument of your choice. Take a look at the following graphs.
You can see from the graphs above that the neckline can move in a straight line, move slightly up or slope down and it can be characteristic for specific instruments. Some traders prefer to identify a pattern with a strong descending neckline while others may prefer a strong ascending neckline. However, keep in mind that there are traders who open positions based on different setups of the pattern. Try to find the right setup for your instrument of choice.
Head and shoulders trading
You already know that the neckline plays an important role in identifying potential entry points based on the head and shoulders pattern because it can act as a support or resistance level. Now, here is how to execute buy and sell orders:
- Sell trade – in a bearish head and shoulders chart pattern the price breaks below the neckline, which acts as support level;
- Buy trade – in a bullish (inverse) head and shoulders pattern the price moves above the neckline, which represents the resistance level.
The head and shoulders formation can also help traders define their stop-loss as well as take profit levels. The profit target level can be estimated using the highest point of the head and the neckline in terms of the distance between the two. Hence, this distance would serve as a target where you can exit your position and collect potential profits. However, this doesn't mean that the price will reverse after this distance is reached. The target distance merely serves as an indicator about the minimum distance we can expect for the price to move in the new direction. Of course, since the price can move even further, traders can place a bigger target, but this is entirely up to them and you.
Trading the head and shoulders pattern means that you need to place a stop-loss order to limit your exposure. You can place it at the top of the head, but this will provide a low risk-reward ratio. Hence, during a bearish pattern, traders can wait for the price to consolidate and show small pullbacks close to the support level (the neckline) and place their stop-loss orders near the highs of the price consolidation when the price moves further down. By placing the stop loss level near the top of the consolidation, you will have an adequate risk-reward ratio.
Another level you can place a stop loss is by looking at the right shoulder where you can define a stop loss at the high of the shoulder or above the shoulders top. Of course, ultimately, the stop loss level is your decision in terms of your personal preference for risk-reward ratio as well as the instrument you are trading.
An example of how a bullish reversal would appear using the head and shoulders pattern is shown in the following graph.
An inverse head and shoulders pattern signaling bullish trend reversal is presented for the currency pair EUR/HKD. You can see that a left shoulder is formed when the price reaches a low point, after which there is a retracement and a new lower low is formed, which is the head. Afterwards, the price pulls back and again falls but to a higher low. After the price breaks above the neckline, the upward trend continues.
Noteworthy mentioning is that although the chart pattern identifies potential trend reversals successfully, traders confirm their signals by considering the volume levels as well as other technical analysis indicators. The former is especially important during a strong moving trend, the reason being that a head and shoulders pattern can be identified, but the trend may continue its direction without reversing. So, it is of crucial importance that you are acquainted with the market structure.
Advantages of the head and shoulders pattern
- Beginner traders can easily use it, but experienced traders will have the biggest benefits;
- Although not recommended, it can be used standalone to identify potential buy and sell signals,
- Opportunity to make adequate risk-reward ratio and make significant gains
- The head and shoulders chart pattern is applicable for different instruments
Drawbacks of the head and shoulders pattern
- A head and shoulders pattern can be easily detected on your chart but you should identify the characteristics of the pattern for different instruments so you would know when to place stop loss and when to take the profit.
- Although inexperienced traders can use this pattern, they should test the pattern before they enter positions.
- Can provide misleading signals during a strong upward or downward moving trend.
FURTHER READING: How to read and use the Williams %R trading indicator