The head and shoulders is a chart pattern that is fairly considered one of the most popular and known among the traders. It is quite easy to spot on the chart of any trading instrument. When it comes to text description, the head and shoulders is a pattern from technical analysis and it represents three peaks with a baseline. The highest peak should be the middle one.
The current chart pattern is used to define the trend reversal from bullish to bearish state. It can be detected on all the timeframes of every single asset. Its simplicity allows to use it not only by professional traders and investors but by novice traders as well. The nature of the pattern allows defining precisely the levels for entries, the stop levels, and take-profit areas. No ambiguous signals are given by this pattern that is why it is popular.
How does Head and Shoulders pattern look like?
As mentioned above, the base of the pattern is three peaks. They come from human anatomy and look like two shoulders and one head.
- Left shoulder: The asset price starts rising and afterward the peak is formed there comes a non-significant price decline.
- Head: Exactly after the decline the price starts to grow and forms a new high (higher than the left should peak price).
- Right shoulder: After the head peak is formed, there comes a decline that comes as low as the bottom price of the left shoulder. Then some bounce up occurs, which peak price is lower than the head. And eventually, the price drops again, finishing the formation of the pattern.
Due to the fact that all assets have different behavior and timeframes have their own specific characteristics, the formations are not ideal. It means that the shoulders may differ in length, the head might be printed by the noisy price action, etc.
Figure 1. Head and Shoulders pattern on NZD/USD H4 Chart
How to place the neckline of the Head and Shoulders?
The first step to place the neckline is to define the left shoulder, head, and right shoulder as mentioned and shown on the chart above. In the conventional head and shoulders pattern, we put a line from the low of the left shoulder to the low of the right shoulder. By doing this we create the so-called “neckline” of the pattern. It is shown with the red line on the chart above. It is highly important, therefore its key points will be expanded in the following text.
It is important to notice that the necklines can be not only horizontal. There are hundreds and thousands of market participants so the patterns do not appear to be ideal. Therefore, the neckline might be drawn with a small angle. One of such examples with the inclined necklines will be shown below.
How to Trade the Head and Shoulders Pattern?
One of the main factors that is vital for the successful trading of this pattern is to wait for the pattern to form completely. This is applicable for all the patterns because they may develop incorrectly or not develop at all. Partial or incorrect patterns lessen the quality of the signal therefore no trades should be taken.
For the particular head and shoulders pattern completing means the break of the neckline. Here we have to wait for the price to go below the neckline formed after the peak of the right shoulder and only afterward enter the trade. Though, the smarter idea will be to define the trade details beforehand and to locate not only the entry, but also the stop-loss, and profit target. That is essential to meet the risk-management rules.
One of the most conventional entry points, as mentioned earlier, is when a breakout occurs, i.e. price breaks the neckline so there is a signal to enter the trade. This type of entry is described in the majority of the books about technical analysis and in the manuals about this pattern.
Another widely used approach is to wait for the breakout to occur and enter the trade only when the price comes back to the broken neckline. This method definitely adds power to the signal and is considered more conservative. One of the main disadvantages could be the fact that the trade may not occur in case if the price keeps moving in the direction of the breakout without any retrace.
Figure 2. Head and Shoulders pattern on Brent M5 Chart
On Figure 2 Chart above there is displayed an entry type when the pullback should be awaited. The last blue arrow shows when the retrace occurred that gave a perfect entry point with a tight stop-loss and huge Risk:Reward ratio.
Stop loss and take profit for the pattern
The mentioned earlier fact that stop-loss and take-profit are vital for the pattern should be expanded. In the conventional trading approach, the stops are located slightly above the high of the right shoulder but the trade should be executed only after the neckline is broken.
Another approach is to use the head (top) of the pattern as a stop. Though it leads to a much larger risk and also reduces the potential reward to risk ratio of the trade. Therefore it is better to use some kind of scalping approach and to have more tight stop-loss trades instead of one but big. In the above-located chart, the price of the stop-loss would be at $53.65 once the trade was taken.
The conventional approach for take-profit is to calculate the distance between the head and the low of either shoulder. This difference should be afterward subtracted from the neckline of the pattern to provide a take-profit price to the downside.
Figure 3. Head and Shoulders pattern take profit on Bitcoin M30 Chart
In Figure 3 chart the distance from the top to the neckline is equal to 2,400 USD (40,400 – 38,000). Therefore, the target should be placed at the price of 35,600 USD (38,000 – 2,400). When the price reaches this level, the trade should be closed.
Sometimes traders have to wait a long time for the price to reach the initially defined take-profit but in the case above it came to the target within several hours and allowed to get decent profit with a very decent risk to reward ratio.
Does the head and shoulders pattern work?
There are no patterns that always work and every single one has its own probabilities. Though the head and shoulders pattern has quite a high win ratio and there are some reasons (with market mechanics) why it works:
- When the price of the asset drops from the high (head in our case), the sellers start accumulating their positions and buying the temporary formed dip.
- After the future neckline of the pattern is reached, the ones that have bought during the formation of the right shoulder now understand that they have been wrong and seeing losses on their accounts. The logical action would be to exit positions, and that will push the prices below to the defined profit target.
- The stop-loss above the right shoulder is objective because the movement has shifted its direction downwards. Due to the fact that the right shoulder is lower than the head, it is unlikely to be broken by the price until an uptrend takes into action.
- The take-profit target is logical because the traders that purchased the asset and appeared to be wrong will be forced to eliminate their positions. Closing of buy positions creates a flow of selling orders pushing the price lower.
- This is a known fact that the majority of trades put their stops below the low. The neckline is the point below which the majority of stop-losses are located and where the traders are feeling the pain of losses thus closing their positions.
- When a breakout of a significant level occurs, it is usually accompanied by a volume increase. It is an ideal sign that the down move will continue. The larger volume means the larger potential of the drop. When the volume is decreasing it shows a lessening interest and therefore the trade might be closed before the target is reached.
The cons of the pattern
As mentioned above, there are no perfect patterns and the current one is not an exception. Here are some pitfalls that a trader may face when trading it:
- You need to monitor charts of several instruments and timeframes to find the patterns. Moreover, you should have enough patience to wait until it is completely formed. There are many cases when the left shoulder and the head are formed but the price struggles to complete the pattern with the right shoulder.
- The pattern has its win ratio and it is not 100% so sometimes the stop-losses may be hit so it’s obligatory to follow risk-management rules.
- The profit target may not be reached due to some obstacles so it is not a ‘set and forget’ setup. Monitoring the price behavior should be in the routine of every single trader so it will allow to get out when there are some signs of the reversal.
- As mentioned in the very beginning, drawing the head and shoulders pattern is quite subjective. Some may not see a shoulder, where others do. So a better approach will be to search for the ones that are clear and do not give ambiguous signals.
Head and shoulders patterns form on all the instruments and on all the timeframes. The simplicity of the pattern allows to use it in the trading strategy and to increase the probabilities of the trading setups. The pattern consists of the left shoulder, a head, and a right shoulder that is pretty clear in terms of market mechanics and visual understanding. The most usual entry point could be a breakout of the neckline (link of the lows of the shoulders). The more powerful signal is to wait until the retrace to the broken neckline. The stop in both cases should be located above the high of the right shoulder. The profit potential should be calculated as the difference between the high of the head and the neckline. Overall, this pattern is not very perfect, but it definitely provides high probability signals and could be used by traders with a different experience.