The Head and Shoulders – How to Trade this Chart Pattern

The Head and Shoulders – How to Trade this Chart Pattern

The Head and shoulders pattern is one of the most well-known and profitable figure in financial markets and technical analysis. It’s a reversal pattern for price action and might spot early signs of change in market trend. It usually appear at the end of a protracted ascending trend, or at the end of a long downside movement.

You cannot trade the market if you don’t know it!

What you will learn today

  • The Construction of Head and Shoulders Pattern;
    • The Traditional Head and Shoulders;
    • The inverted Head and Shoulders;
  • How to Trade the Head and Shoulders Pattern;
    • Wait for a pullback!;
  • Conclusions;

The Construction of Head and Shoulders Pattern

This pattern of inversion usually develops during phases of consolidation, in which price tends to move sideways without a clear and strong direction. Indeed, the particular shape of this formation requires time to develop in the market.

The head and shoulders develops forming three peaks (in the traditional H&S version) or three troughs (in the inverted H&S). Now, let’s discuss about both of them more in details.

The Traditional Head and Shoulders

The traditional head and shoulders is a reversal formation showing three peaks in the market. Look at the picture below:

An head and shoulder market in US stock market

We can observe three different impulses, and three subsequent retracements. Let’s now discuss more in details about the pillars of this structure.

The left Shoulder

The first shoulder develop after an up movement, usually followed by increasing volumes. Price reaches a relative maximum, then retraces backward to previous low.

The Head

In this phase, we observe a new impulse, pushing price above previous relative high. During this phase, usually volume follow price action, despite starting to show first signs of weakness. This condition could be a clue for a potential inversion in market action, with Buyers gradually losing control in favour of Sellers.

The Right Shoulder

The second (right) shoulder, provide us a final confirmation of potential inversion in market action. We experience a lower relative high, showing an increasing selling pressure which overwhelm buying one: buyers are not able to re-acquire control. A this point, sellers are in full control and price is pushed lower towards towards the neckline.

The Neckline in a Traditional Head and Shoulders

An Head and Shoulder formation is completed only once the neckline is invalidated. It is a simple trendline drawn between the point which identify the beginning of the Head impulse (point A), and the point which identify the beginning of the right shoulder (point B).

The neckline identify a powerful level of support for price action. We have a complete pattern is complete once price breaks this level. Usually, a spike in volume follow the breakout: this is a strong price confirmation for a potential shift in market direction.

The inverted Head and Shoulders

Let’s now discuss about the “other side of the moon” moving our attention of the Inverted Head and Shoulders pattern. This reversal formation often shows itself at the bottom of a protracted downtrend in which price is ready to invert its run moving upward.

Look at the picture below:

An inverted head and shoulders on MSCI emerging market ishares etf

As for the traditional H&S, we can observe three different impulses, and three subsequent retracements. Let’s now discuss more in details about the pillars of this structure.

The left Shoulder

The first shoulder develop after a down movement, usually followed by increasing volumes. Price reaches a relative minimum, then retraces backward to previous high.

The Head

In this phase, we observe a new impulse, pushing price below previous relative low. During this phase, usually volume follow price action, despite starting to show first signs of weakness. This condition could be a clue for a potential inversion in market action, with Sellers gradually losing control in favour of Buyers.

The Right Shoulder

The second (right) shoulder, provide us a final confirmation of potential inversion in market action. We experience an higher relative low, showing an increasing buying pressure which overwhelm selling one: sellers are not able to re-acquire control. At this point, buyers are in full control and price moves higher towards towards the neckline.

The Neckline in an Inverted Head and Shoulders

An Head and Shoulder formation is completed only once the neckline is invalidated. It is a simple trendline drawn between the point which identify the beginning of the Head impulse (point A), and the point which identify the beginning of the right shoulder (point B).

The neckline identify a powerful level of support for price action. Once this level is broken, the pattern is completed. Usually, a spike in volume follow the breakout: this is a strong price confirmation for a potential shift in market direction.

How to Trade the Head and Shoulders Pattern

As stated before, we identify an Head and Shoulder formation, whatever traditional or inverted, only when price breaks above or below the neckline level, not before!

Market entry should be placed at the breakout of this level. Then, the minimum target price is equal to the 1:1 projection of the distance between the highest point of the Head and the Neckline, projected by the breakout point (see the following picture):

How to trade head and shoulder pattern and find price targets in the market

Nevertheless, this is only a minimum target. There are not precise formulas of methods to estimate the maximum price extension after a breakout, but the projected 2:1 or 3:1 are important target of second and third level.

Wait for a pullback!

Sometimes (I would say often) price retests the broken level, bouncing backward to the neckline. The pullback represent an excellent point to enter in the market, in a trend following condition, but in a better position able to increase the risk-to-reward ratio.

In stock market, a pullback followed by decreasing volume, can be seen as a good signal pro-trend: in this case, this pullback represents just the take profit activities of some of the market participants but it does not affect overall trend.

A double top nearby an H&S neckline

Conclusions

Head and Shoulders represents one of the most traded chart pattern. Its development is frequent in the market and the rules of formation are very simple. Despite this, in real market often this pattern appear in a more complex manner, without a clear shape as represented in the theory.

Nevertheless, I think you should definitely consider to implement it in your daily trading when studying the action of price in financial markets. I’m sure you will find it useful to improve your overall results!

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