The head and shoulders pattern is one of the most widely followed and traded chart patterns among technical analysts. This powerful reversal pattern can signal when a market is about to make a major trend change.
In this comprehensive guide, we’ll cover everything you need to know about the head and shoulders pattern, including:
What is the Head and Shoulders Pattern?
The head and shoulders pattern is a reversal chart pattern that forms at the end of an uptrend or downtrend. It gets its name from the visual shape of a left shoulder, head, right shoulder that forms on a price chart.
The pattern signals that the prior trend is about to reverse once the neckline is broken. It is considered a reliable trading signal for trend changes.
Key Features of the Head and Shoulders Pattern:
- Forms at the end of an uptrend or downtrend
- Creates a shape with three peaks – left shoulder, head, right shoulder
- Neckline connects the lowest point of each shoulder
- Head is the highest peak in the middle of the pattern
- Shoulders are lower and align at similar price levels
- Break of neckline indicates reversal of prior trend
How to Identify the Head and Shoulders Pattern
There are some key characteristics to look for when identifying the head and shoulders pattern on a chart:
1. Uptrend or Downtrend
The head and shoulders pattern forms only at the end of an extended uptrend or downtrend. Look for the pattern to emerge after a market has been trending higher or lower over a period of time.
2. Left Shoulder Peak
From the prior trend, the market will make a moderate peak representing the left shoulder top. This peak is lower than the eventual head peak.
3. Decline from Left to Head
After forming the left shoulder, the market will decline for a period creating the low point between the left shoulder and head.
4. Head Peak
Next, the market will make its highest peak representing the head portion of the pattern. The head is the largest and highest peak of the overall pattern.
5. Decline from Head to Right Shoulder
After reaching the head peak, the market will again decline creating the low point between the head and right shoulder.
6. Right Shoulder Peak
At the end of the pattern, a second lower moderate peak forms representing the right shoulder. This peak aligns around the same level as the left shoulder peak.
7. Neckline
Connecting across the lowest points between the left shoulder, head, and right shoulder forms the neckline. This is the major support level to watch for the pattern breakout.
8. Break of Neckline
The head and shoulders pattern is considered complete once price action breaks below the neckline after forming the right shoulder. This signals the prior uptrend is reversing into a new downtrend.
9. Volume Signs
Often times, but not always, volume will be highest on the head portion and lighter on the left and right shoulder peaks. An increase in volume on the neckline break can confirm the pattern.
Variations of the Head and Shoulders Pattern
Beyond the standard head and shoulders, there are inverted and complex variations:
Inverted Head and Shoulders
The inverted head and shoulders pattern forms at the end of a downtrend and signals a reversal to the upside. It contains the same elements flipped upside down – low head and higher left/right shoulders.
Complex Head and Shoulders
The complex head and shoulders has multiple left and/or right shoulders. These extra peaks make the pattern larger but also more reliable when a neckline break finally occurs.
How to Trade the Head and Shoulders Pattern
Now that you know how to spot the head and shoulders chart pattern, let’s discuss how to actually trade it:
Set a Neckline Alert
Use your charting platform to draw in the visible neckline and set a price alert when it is broken. This will signal the pattern has triggered and the new trend reversal has begun.
Place Stop Loss Order
Once the neckline is broken, place a stop loss order just above the recently broken support. This will limit risk in case the breakout turns out to be false.
Enter Short/Long Position
After the neckline breakout, initiate your position in the direction of the new trend. For an upside down head and shoulders, go long. For a standard pattern, enter a short position.
Target Minimum 1:1 Risk/Reward
Set your target take profit level so that the trade gains at least as much as it risks from the stop loss. A 1:2 or 1:3 risk/reward ratio is ideal for this pattern.
Manage Trade at Neckline
If the initial breakout fails and price returns back above the neckline, close out the trade. The pattern has failed to reverse the prior trend.
Best Practices for Trading Head and Shoulders Patterns
Follow these tips to improve your head and shoulders trading strategy:
- Trade only high volume securities to ensure sufficient liquidity.
- Confirm breakout with increase in volume for robust signals.
- Use Fibonacci retracements to set optimal stop loss and profit target levels.
- Scale into position size to spread risk over time.
- Book partial profits at target extensions – 1.618, 2.618, 4.236 Fib levels.
- Move stop loss to breakeven once pattern hits initial targets.
- Focus trades on daily or weekly charts for the most reliable signals.
- Combine with other indicators like MACD or RSI for confirmation.
- Avoid pattern trades late in extended trends where breakouts are prone to failure.
Pros and Cons of Head and Shoulders Pattern Trading
Here are the main advantages and disadvantages of trading head and shoulders patterns:
Pros
- Highly reliable reversal signal when confirmed.
- Clear stop loss point defined by neckline.
- Rewarding risk/reward profit potential.
- Versatile trader for range bound or trending markets.
- Easy to spot pattern for novice technicians.
Cons
- Not ideal for highly volatile instruments.
- Early breakout entries prone to being stopped out.
- Harder to spot valid patterns during range bound markets.
- Not effective in very long-term trends.
- Can develop slowly, requiring patience.
FAQs About Head and Shoulders Patterns
Here are answers to some frequently asked questions about the head and shoulders trading pattern:
What market conditions are best for trading head and shoulders patterns?
Head and shoulders patterns work best in range bound or moderately trending markets on the daily or weekly time frame. Avoid choppy short term markets and extremely extended long-term trends.
Does a perfect symmetrical shape matter when trading?
No, the left and right shoulders do not need to align perfectly or match the slope of the neckline. The overall shape and pattern sequence are more important than visual perfection.
How far should the stop loss be set below the neckline?
Typically the stop loss is placed just below the neckline allowing for some wiggle room in case of false breakouts. Around 1-3% maximum risk per trade is recommended.
When is the ideal time to take profits on a head and shoulders trade?
Take partial profits at key Fibonacci extension levels after the entry triggered by the neckline break. Move trailing stop to breakeven once the minimum 1:1 target is reached.
How can I confirm a breakout signal before trading a head and shoulders pattern?
Look for increased volume on the break for confirmation. Use other indicators like MACD crossing centerline in direction of break or oversold/overbought RSI levels to add confidence.
Should I avoid partial or imperfectly formed head and shoulders patterns?
Partial formations and complex patterns with extra shoulders are normally still tradable. Focus on the sequence of peaks and valleys rather than perfect symmetry.
Final Thoughts on Trading Head and Shoulders Patterns
The head and shoulders pattern is one of the most well-known and traded chart patterns among technical traders. Correctly spotting this reversal signal at the end of trends can provide reliable entries into major new trend moves.
However, no chart pattern works perfectly in all markets. Always use prudent position sizing, stop losses, and confirmations filters to improve the odds of success.
Remember to trade defensively and book profits along the way once your minimum target is reached. Learning to spot reliable head and shoulders patterns takes practice, but can reward pattern traders for years to come.
“If you don't find a way to make money while you sleep, you will work until you die.”
- Warren Buffett
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