What is the Head and Shoulders chart pattern?
As a constituent of technical analysis, a Head and Shoulders pattern describes a specific chart that indicates, with varying degrees of accuracy, a possible bearish or bullish trend reversal. It is believed to be one of the most reliable trend reversal patterns available today.
The pattern appears on all time frames, making it easy to be incorporated into the trading strategies of investors, as well as day and swing traders. Price targets, entry levels and stop levels make the Head and Shoulders formation attractive for both novice and expert, as it provides important and easy-to-see levels.
Its name comes from the visual characteristics of the chart resembling the shape of a head and two shoulders. In fact, there are two types of the Head and Shoulder pattern, but first things first.
Every Head and Shoulders pattern consists of:
- The left shoulder
- The right shoulder
- The neckline (or pullback line)
The creation of the pattern on the chart starts from the left shoulder. The price action then forms the head, which is higher or lower (depending on the type of the pattern) than the left shoulder. The right shoulder is created afterwards; typically, it is approximately at the same level as the left shoulder. The neckline is applied at the end of the formation; it may be horizontal, descending or ascending.
It is important to note that formations are rarely perfect, meaning there may be some noise between the respective head and shoulders; the latter may be uneven in relation to each other.
It is important not to confuse the reversal pattern with the continuation pattern. The former is usually at least as large as the typical price wave in the trend that precedes it. If the Head and Shoulders pattern looks very small compared to the price waves around it, it may indicate the continuation pattern.
Head and Shoulders Top
The regular Head and Shoulders pattern forms at the top of the uptrend and is referred to as the Head and Shoulders Top. Considered to be a bearish chart pattern.
The left shoulder forms at the end of a significant bullish period in the market. After its apex is formed, the price of the underlying asset tends to slide down to a certain extent as a subsequent reaction. The head is then formed when the price increases again, creating the highest vertex of the pattern. It is then followed by another price decline. The right shoulder forms when the price moves up again, however, remaining below the head. It then falls down nearly equal to the first valley between the left shoulder and the head or at least below the apex of the left shoulder.
At last, the neckline is drawn across the bottom of the head and both shoulders serving as a support line. When the price breaks through the neckline, after forming the right shoulder, and keeps continuously falling, it indicates the completion of the Head and Shoulders Top formation.
Head and Shoulders Low
The Head and Shoulders pattern can also form in the opposite direction. Also known as the Head and Shoulders Bottom or the Inverted Head and Shoulders, the bullish version of the pattern establishes at the bottom of the downtrend and implies that the existing bearish tendency is likely to be reversed, and the price will head higher.
After the peak of the left shoulder is formed, the price goes up completing the first formation. Then it falls down to a new low followed by a recovery move upwards creating the head. A corrective reaction downwards occurs to start the formation of the right shoulder, and then the price makes a sharp move up once again. The neckline is then applied, serving as a resistance line. Once the second shoulder is formed, the price will make a final rally, breaking through the neckline and indicating the completion of the Head and Shoulders Bottom formation and the reversal of the bearish trend.
Another difference between the Top and Bottom patterns is that the Top formation is typically completed within a few weeks, whereas the Bottom formation may prolong up to several months or even a year.
How to interpret the Head and Shoulders pattern
When dealing with the Head and Shoulders Top pattern, measuring the vertical distance from the top of the head down to the neckline helps to determine an estimated spread amount. For instance, if the distance represents $10, then once the neckline is broken, technical analysts would predict the price to decline at least another $10 below the neckline price level. Conversely, when dealing with an inverse pattern, the opposite is true: measuring the vertical distance from the neckline down to the peak of the head gives you a rough idea of how far the price is likely to go upward past the neckline.
Why is the Head and Shoulders pattern useful for traders?
The Head and Shoulders pattern is a useful technical analysis tool for measuring and evaluating the minimum probable extent of the subsequent move of the price from the neckline. It also allows indicating a reversal in a trend where the market makes a shift from bullish to bearish or vice-versa. This pattern is considered to be one of the more reliable patterns that predict a trend reversal.
Knowing how to recognise the pattern and base a trade on it can be fruitful in the long term. It can also be seen as another great technique to implement in your overall trading strategy.
How to trade the Head and Shoulders pattern
Before making any trades, it’s important to let the Head and Shoulders pattern fully form itself. If the pattern is still not complete, you shouldn’t assume that it will fully develop and make trades upon that belief. The market is volatile; it always changes at a rapid pace.
Partial or nearly completed patterns should be observed, but no trades should be made until the pattern breaks through the neckline. Stay patient and plan your trades beforehand, writing down the entry, stops and profit targets, so you’ll be ready to act once the neckline is broken.
When trading the Head and Shoulders Top pattern, you expect the price action to move lower than the neckline. Calculate a profit target for the trade by measuring the height of the pattern from the peak of the head to the neckline. Open a short position when the pattern completes and price breaks below the neckline.
The inverse pattern is traded the same way. With it, you expect the price movement above the neckline. Find the difference between the high and low of the pattern to calculate the profit target. Take a long position when the price breaks above the neckline.
In both situations, you can exit your position near the set target or keep it longer if the price continues to move in your favour until the next reversal signal develops.
The key to mastering the Head and Shoulders trading is to be patient and wait for the pattern confirmation, as sometimes fake-outs might occur. Don’t forget to set your stop-loss orders. With the Top pattern, stops are typically placed above the high of the right shoulder or above the high of the head price. With the Bottom inverse pattern, stops are usually placed below the low price formed by the head pattern.