The infamous “Head and Shoulders” trading pattern. Many technical traders have memorized hundreds of candle and chart formations. You may know what the Head and Shoulds trading pattern is, but that’s not what got you to this post. You want to know how to trade this infamous trading pattern. In this post, we’ll go over what the Head and Shoulders pattern is, how to trade using the head and shoulders pattern, what timeframes you can use with the head and shoulders pattern, and what markets you can use the head and shoulders pattern in.
What is the “Head and Shoulders” Trading Pattern?
So for starters, if you don’t know what the Head and Shoulders pattern is, it is a bearish trend reversal formation. In other words, if you see a head and shoulder pattern while you are charting your favorite stocks or currencies, the trend will more than likely be broken. If you think of a person and look at them on a wall. Generally, there are two shoulders on each side of the head resting roughly on the neckline.
The left shoulder in a chart forms a peak, touches the neckline, followed by a higher peak (head), and then another lower peak, or the right shoulder, followed by another test of the neckline. The neckline is the support line where both of the shoulders rest. We can all imagine what a person looks like, so let’s show some charts so we can show you what we’re talking about.
As you can see the stock made a bearish head and shoulders, trend reversal pattern. It made a peak on the left shoulder, a month later made a higher peak on the head, and a month after that made a lower peak on the right shoulder. Typically the regular head and shoulders pattern is viewed as bearish, but it can also be used for bullish setups. The inverse of a “Head and Shoulders Pattern”, or the inverse head and shoulders pattern, is a bullish setup. Imagine someone doing a hand stand, that is essentially what the inverse will look like.
We took the same head and shoulders pattern above and just simply flipped it showing the bullish use of an inverse head and shoulders pattern. Hopefully you get how to spot one while charting and recognize it as a trend reversal pattern and something big is about to happen. Before going onto how to trade using the head and shoulders pattern we want to point out that not all head and shoulders patterns will be as straightforward as the ones seen above. The neckline will not always be a perfect horizontal line, in fact, it can be an uptrend line or a downtrend line, pictured below.
How Do I Trade a Head and Shoulders Pattern?
Okay, so now that you know how to chart the pattern, how do you trade it? First off, the success rate of the Head and Shoulders pattern is one of the highest in all of the technical chart patterns. As a trader, it is very important to initiate a trade AFTER confirmation. Ideally, you would want to wait until the price action goes below the neckline after the right shoulder is formed. Typically, when the price breaks the neckline, there will be a surge downward and a bounce back to the neckline. The most common entry point is when the price breaks out of the neckline. This can be said the same on the inverse head and shoulders pattern. See examples listed below of the pictures above.
Now for a typical trade, you will want to set stop losses and price targets to protect your gains and losses. The ideal stop loss will be just under or over the neckline depending on regular or inverse. Typical price targets will be calculated from the tip of the head to the neckline, as seen in Exhibit A & Exhibit B. It doesn’t matter if it’s the regular pattern or the inverse pattern, the calculation will be the same.
For example in Exhibit A, the tip of the head is ~$16.50 and the neckline is $14, subtract the two and puts you at a price target $2.50. Now subtract $2.50 from the neckline, and the price target will be $11.50.
Again, to reiterate, WAIT FOR CONFIRMATION. In Exhibit A, when the stock closes below the neckline, that would be the ideal entry point with a stop loss at the neckline. In Exhibit B, when the stock closes above the neckline, it is an ideal entry point with a stop loss slightly under neckline.
What Timeframes Can the Head and Shoulders Pattern Be Used On?
The good thing with this pattern, is that you can trade it on any time frames. 1min, 5min, 10min, daily, weekly, you name it. However, it is worth mentioning that the longer the time frame, specifically daily or longer, the more solid chance the pattern will confirm.
What Markets Can I Use the Head and Shoulders Trading Pattern?
The beauty of most technical trading patterns is that they can be used in whatever market you are used to or are trading. Whether it be OTC, Forex, options, stocks, cryptos, you name it. The head and shoulders pattern is applicable in any market that allows you to chart price movement.
Head and Shoulders Conclusion
To wrap this post up, we’ve gone over what the Head and Shoulders pattern is, how to trade the pattern, what timeframes it can be used on, and what markets it’s applicable to. This pattern is one of the most reliable technical patterns with an over 85% success rate. What that means is that it CAN fail and it isn’t a guarantee. So make sure to set stop losses and price targets to reduce stubbornness and greediness.