How to identify and trade the Head and Shoulders pattern
The Head and Shoulders pattern is a reversal pattern that occurs during uptrends. This formation is considered to be very reliable, although it is not a very common formation. In this blog post, we break down the Head and Shoulders pattern and how to benefit from trading it.
Head and Shoulders is a bearish reversal pattern. Its bullish equivalent is called the Inverted Head and Shoulders pattern as it occurs during downtrends and the head actually represents the lowest point of the formation. Hence, Inverted Head and Shoulders formation looks the same as the standard Head and Shoulders, but inverted. All basic rules that apply to standard version also apply to the inverted one.
Structure of the Head and Shoulders pattern
As seen in the image below, the Head and Shoulders pattern is characterised by three peaks, where the middle peak is the highest. The left peak represents the left shoulder while the peak on the right side of the highest peak is the right shoulder.
Another important element of this structure is the neckline. Many analysts consider the neckline to be the most critical point of Head and Shoulders pattern. The neckline is defined as a line which connects the first and second troughs. It also serves as an activation point i.e. a break of the neckline activates the Head and Shoulders Pattern. Until the neckline is broken, we consider the pattern to be still in development and we don’t initiate trades based on it.
The right shoulder also bears an important psychological message. Up to that point, all previous peaks were characterised as higher highs i.e. the price action was in a clear uptrend. Thus, the third peak is the first time that the bulls were unable to push the price action to a new high, which essentially initiates a correction.
The basic rule of the Head and Shoulders pattern is that it should occur only during a clear uptrend. One of the basic trading mistakes relating to this formation is that analysts and traders identify three peaks that resemble Head and Shoulder that occur as the asset trades sideways.
Once the trend is identified, the structure should clearly resemble a three-peak formation. Once we have clearly defined two shoulders and a head, we move to connecting the lowest points of the two troughs and forming a neckline. You shouldn’t be confused if the neckline is slightly bent to one or the other side as it is almost impossible to draw the neckline fully horizontally.
Finally, the pattern is only confirmed once the neckline is unambiguously broken. For this to happen, traders are advised to wait for a clear close on a daily time frame below the neckline in the standard Head and Shoulders pattern, or above the neckline in the Inverted Head and Shoulders formation. As explained above, the neckline acts as the trigger line for the activation of the pattern. Up to that point, Head and Shoulders pattern was only in development mode.
Trading the Head and Shoulders Pattern
In the chart below, we explain how you should trade the Head and Shoulders pattern. As the price action moved in the uptrend, we form three peaks, whereas the right shoulder is the first lower high. The price action starts correcting lower as it approaches the neck line.
Once we have a clear breakout below the neck line, we consider opening a trade. There are two different entry points generated by this formation: 1) We initiate the trade as soon as the price closes below/above the neckline and try to catch the first train or, 2) we wait for the price to break the neck line and then return for a re-test.
Many traders prefer using the second approach as it is more reliable. The first option may result in a failed breakout if the price action returns below the neckline. This is why more experienced traders wait for a retest to act as a double confirmation. In this case, the retest happens quite late.
Either way, a stop-loss order should be triggered if the price action returns above the neckline. In this case, the entire pattern is invalidated as no followthrough has been ensured.
On the other hand, the take profit order is calculated by measuring the distance between the tip of the head and the neckline. This line should be copied and applied below so that it starts from the break point of the neckline and extends to the downside.
The point where the copied trend line ends is the profit-taking level.
Summary of trading Head and Shoulders
- Head and Shoulders is a bearish reversal pattern, unlike the Inverted Head and Shoulders, which is a bullish reversal pattern.
- It’s a reliable but not a very frequent formation.
- Neckline acts as the trigger line for the activation of the pattern.
- Take profit order is calculated by measuring the distance between the tip of the head and the neckline.
- A return back above the neckline invalidates the pattern.