The Head and Shoulders Pattern

Whilst movements on an asset’s price chart often look totally random, sometimes observant traders will notice similar patterns repeating themselves. These patterns are often used by traders to attempt to predict future price movements and, consequently, form the basis for many a trading strategy.

The “head and shoulders” is one such pattern. In this article, we will take an in-depth look at the head and shoulders pattern, demonstrate how to identify it and provide an example of how to trade it.

What Is the Head and Shoulders Pattern?

The head and shoulders pattern is a chart pattern used by proponents of technical analysis to predict a bearish reversal. An inverse head and shoulders pattern is viewed as a bullish reversal pattern. 

The pattern is formed by a peak, followed by a second higher peak, followed by a third peak which is roughly the same height as the first. Thus, the first and third peaks form the “shoulders” whilst the second peak is our “head”.

The inverse head and shoulders pattern is essentially the same thing but upside down. Whereas the head and shoulders pattern typically appears after an uptrend and indicates a potential bearish reversal, an inverse head and shoulders pattern typically appears after a downtrend and indicates a potential bullish reversal. 

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Identifying the Head and Shoulders Pattern

The best way to demonstrate how to identify the head and shoulders pattern is probably just to show an example of what it looks like.

We can highlight three steps involved in identifying the head and shoulders pattern:

• Following an uptrend, the price rises to a peak (our first shoulder) before pulling back to form a “trough”.
• The price rises a second time, surpassing the previous peak to form a higher high (our head). Once again, the price retreats to form a second trough.
• The price rises once more, reaching a peak (shoulder number two) which is around the same level as the first peak. The price then declines again.

As well as the head and shoulders, a line of support linking the two troughs becomes the “neckline” of the pattern. This is an important part of the puzzle. Its significance will become apparent later once we provide an example of how to trade using the head and shoulders pattern. 

The Inverse Head and Shoulders Pattern

As already mentioned, the inverse head and shoulders is essentially the same pattern but flipped upside down.

As with the pattern itself, the steps involved in identifying the inverse head and shoulders are pretty much the same but inverted:

• Following a downtrend, the price hits a bottom (the first shoulder) before rising.
• The price falls again, reaching a lower low (the head) than previously before moving upwards once again.
• The price falls a third time, hitting a low that is around the same level as the first low (the second shoulder) before rising.

Here, the neckline of the inverse head and shoulders is formed by the line of resistance of the two peaks of the pattern, as shown in the image. Again, we will see the importance of the neckline in the next section when we examine how to trade both head and shoulders patterns. 

How to Trade the Head and Shoulders Pattern

So, now we know what the head and shoulders patterns look like and how we can identify them, how do we trade this pattern?

Both patterns signal a potential reversal. The head and shoulders pattern typically appears at the top of an uptrend and signals a potential reversal to the downside, whilst the inverse head and shoulders typically appear at the bottom of a downtrend and signals the opposite.

Traders should wait until the entire pattern has completed before taking a position rather than trying to anticipate it ahead of time. So, what is the cue to enter the market?

Remember when we said that the neckline was important? Well, this is where it comes into play.

Trade Entry

A commonly used signal to enter the market arrives when the price breaks through the neckline, at which point a trader may choose to enter a short (sell) position in the case of the normal head and shoulders pattern or a long (buy) position in the case of the inverse pattern. 

In the image below, we can see that, following an uptrend, a head and shoulders pattern has formed. As the price breaks below the neckline, this could serve as a signal to enter the market.

Of course, more cautious traders may choose to wait for further confirmation of the move before initiating a trade. However, this approach may cause the trader to miss the move altogether.

Stop Losses and Profit Targets

Stop Losses and Take Profits play an essential role in any risk management strategy. Where to place these levels is at the discretion of each trader and will largely depend on individual appetite for risk.

In terms of the stop loss, it is common for them to be placed above the right shoulder or the head. Naturally, placing the stop above the head will be accompanied by a much higher level of risk for the trade.

Again, profit targets are subjective depending on the individual trader. However, when trading this pattern, take profit levels are often placed the same distance away from the neckline as the head of the pattern. In other words, traders measure the distance between the neckline and the head and subtract/add this to the neckline to find the appropriate profit target level.

Conclusion

The head and shoulders pattern and the inverse head and shoulders pattern are both interpreted as signals of a potential price reversal. They can appear in all markets, on all time frames and the pattern can provide traders with entry, stop loss and profit target levels.

Once traders have become accustomed to the pattern, it can be easy to spot but bear in mind they won’t always look perfectly like the examples provided in this article. Indeed, as with other chart patterns, sometimes identifying the head and shoulders pattern can be somewhat subjective.

It's important to note that this is not an exact science. Whilst head and shoulders patterns are considered to signal price reversals, that doesn’t mean that a reversal will always materialise.

As with any trading strategy, a head and shoulders strategy will undoubtedly produce false signals. It’s also possible that when reversals do materialise, profit target levels won’t be reached. Consequently, traders may want to consider other conditions for exiting their trade depending on market conditions.

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