The Head and Shoulders pattern is one of the most reliable and widely recognized chart patterns in the world of trading. Known for its distinctive shape and the potential it holds for predicting a reversal in market trends, understanding this pattern is crucial for traders aiming to capitalize on shifts in market momentum. This guide will provide you with a thorough understanding of the Head and Shoulders pattern, including its variations, how to identify it, and strategies for trading it effectively.
Head and shoulders
Inverse Head and shoulders
What is the Head and Shoulders Pattern?
The Head and Shoulders pattern is a reversal chart formation that signifies the end of a trend and the beginning of a new direction in price movement. It is characterized by three peaks: the left shoulder, the head, and the right shoulder. The head is the highest peak, flanked on either side by the two shoulders, which are typically of similar height. The pattern is completed with a neckline, drawn by connecting the lowest points of the two troughs between the peaks.
Variations of the Pattern
- Standard Head and Shoulders: Indicates a reversal from an uptrend to a downtrend.
- Inverse Head and Shoulders: The upside-down version of the standard pattern, signaling a reversal from a downtrend to an uptrend.
Identifying the Pattern
Standard Head and Shoulders:
- Begins during an uptrend.
- Formation of the left shoulder: Price rises to a peak and then declines.
- Formation of the head: A higher peak forms after the initial decline, followed by another decline.
- Formation of the right shoulder: A third peak forms, similar in height to the left shoulder, followed by a final decline to the neckline.
- The neckline can be horizontal or slope up or down. A downward-sloping neckline is considered more bearish.
Inverse Head and Shoulders:
- Begins during a downtrend.
- The formation is the mirror image of the standard pattern, with troughs instead of peaks.
- The final move is upwards towards the neckline after the formation of the right shoulder.
Trading Strategies
- Entry Point: For a standard pattern, enter a short position when the price falls below the neckline after the formation of the right shoulder. For an inverse pattern, enter a long position when the price rises above the neckline.
- Stop Loss: Place a stop loss above the right shoulder for a standard pattern and below the right shoulder for an inverse pattern to minimize potential losses.
- Profit Targets: The profit target can be estimated by measuring the height of the pattern (from the head to the neckline) and projecting this distance downward (for the standard pattern) or upward (for the inverse pattern) from the point of breakout.
Key Considerations
- Volume: Look for increasing volume as the pattern develops, with a noticeable spike on the breakout, as it confirms the pattern’s reliability.
- Neckline Break: Wait for a clear break of the neckline with a candle close beyond it to confirm the pattern.
- Re-test: Often, the price will return to test the neckline from the other side after the breakout. This re-test can provide a second chance to enter a trade.