What is Head and Shoulders Pattern?
The Head and Shoulders pattern acts as a price reversal pattern that enables traders to know when a reversal could be underway as the prevailing trend is coming to an end.
The reversal indicates typically the end of an uptrend.
The Head and Shoulders pattern has a unique appearance that just resembles its name.
The appearance has a distinct ‘left shoulder,’ ‘head,’ ‘right shoulder’ and ‘neckline’ formation.
Qualities of the Head and Shoulders Pattern
Uptrend
The first part of a head and shoulders pattern is the uptrend.
This is the extended part that actually causes the exhaustion.
As a key rule, the reversal is more significant when the uptrend lasts longer.
There is a trader who had sent me an email asking about head and shoulders pattern rules. This is among the things I instructed him to look out for.
It’s just like a ranging market, the longer the range, the more powerful the breakout is most of the times.
Left Shoulder
This is where the market moves down, forming a higher low (HL).
With this, things start to come together in the head and shoulders pattern.
Head
With the left shoulder already formed, the market makes a higher high (HH), which forms the head.
Despite the bullish rally, however, buyers are not able to make a considerably higher low (HL).
Here we now have the left shoulder and the head of the pattern.
The neckline is also starting to take shape, but there is a need to first have the right shoulder before drawing the neckline on the chart.
Right shoulder
The right shoulder is where all the parts come together.
It shows that buyers are tiring and that the market could be preparing for a reversal.
Immediately the right shoulder starts, there is enough to start plotting the neckline.
It is important to think of the progress as a rough draft as the final version is not complete at this point.
Neckline
With a defined head and two shoulders, we can now draw the neckline support.
This level will be an important component in the head and shoulders pattern since it will give us the aspect of when to trade the inherent breakout.
This is the line that separates the buyers’ and sellers’ territories.
Psychology of the H&S Technical Pattern
As earlier mentioned, the Head and Shoulders formation is a reversal chart pattern.
With this, the formation signifies the loss of faith in the dominant trend.
The right shoulder on the chart, which is lower than the head, presents key hints to the trader.
The tops have been rising initially until the creation of the right shoulder, which is the third top.
The decreasing top on the chart signifies the deceleration of the trend that is likely to cause a trend reversal.
Trading the Head and Shoulders pattern
Before making any trades, the Head and Shoulders pattern should first be allowed to fully form.
If the pattern is not completely formed, you shouldn’t assume that it will fully develop and proceed to make trades with that belief.
The market is volatile and changes at a fast pace. You might end up being stopped out.
I always tell my students, don’t try to predict the direction which the market will take, but wait for the market to tell you where it is headed.
Incomplete patterns should be observed, but you should make no trades until the pattern breaks through the neckline.
Remain patient and plan your trades in advance, noting down the entry, the stops and take profit targets, so that you are ready to act the moment the neckline is broken.
As you execute head and shoulders pattern trading, you expect the price action to move below the neckline.
Identify a profit target for your trade by measuring the height of the pattern from the top of the head to the neckline.
Open a short position once the pattern completes, and price breaks below the neckline.
The secret to mastering the head and shoulders pattern chart is being patient and waiting for the pattern confirmation, as in some cases, fake-outs might occur.
Remember to set your stop-loss at all times.
With the top pattern, stops are normally placed above the high of the right shoulder or above the high of the head price.
Inverse Head and Shoulders
As the name signifies, it is a head and shoulders formation just that this time it is upside down.
A valley (shoulder) is formed, followed by an even lower valley (head), and another higher valley (shoulder).
These formations take place following extended downward movements.
It is evident here that this is simply like a head and shoulders pattern, but it’s flipped upside down.
With this detailed content, we would place a long entry order above the neckline, with our calculated target being just like the top head and shoulders pattern.
Measure the distance between the head and the neckline, and that is nearly the distance that the price will move after it breaks the neckline.
The price moves up nicely after it breaks the neckline. If you achieve your target, enjoy with your profits.
There are trade management practices that allow you to lock in some of your profits and still maintain your trades open in case the price keeps moving in your direction.
The Limitations of Head and Shoulders pattern
Similar to other charting patterns, the ups, and downs of the head and shoulders pattern speak of an exact story about the battle between buyers and sellers.
The original peak and subsequent decline represents the fading momentum of the early bullish trend.
With the aim of maintaining the upward movement as long as possible, bulls rally to push the price back up beyond the initial peak to reach a new high or head.
It is still likely that at this stage, bulls could restore their market control and keep the upward trend.
That is why it is important to wait for the completion of the chart pattern before entering the trade.
As soon as the price declines a second time and goes below the initial peak, it is evident that bears are gaining ground.
Bulls attempt another time to push the price upward but achieve only in hitting the lesser high reached in the initial peak.
This failure to exceed the highest high signals the bulls’ defeat and bears take over hence driving the price down and ending the reversal.
It is important to note that head and shoulders pattern will result to trade reversals.
As a result, it is important you observe the manner in which the sellers try to break the neckline.
There are times when there will be fake outs, be keen that you do not fall into the trap.
This is the point when many traders are usually stopped out.
As I keep saying, there is no trading strategy out there, which is 100%. You need to exercise risk management aspects all the time, as a result.
This applies to the head and shoulders pattern too.