The
Head and Shoulders pattern is an important pattern that is frequently used in
technical analysis and signals a potential trend change in the market. The head
and shoulders pattern appears at the end of an uptrend. This pattern consists
of three peaks that form in sequence. The first and third peaks are called the
‘shoulders’, while the highest peak in the middle is called the ‘head’. The
formation appears at the end of an uptrend and gives us signals that the price
may reverse.
How is the Head and Shoulders Pattern
formed?
The Head and Shoulders pattern consists of the left shoulder, head and right
shoulder.
First Shoulder (Left Shoulder): Prices initially continue a historical uptrend,
reach a peak, and then experience a slight pullback. This is not a scary drop
at first, but a minor correction.
Head: After the correction is over, prices rise again and form a new high that
exceeds the first shoulder. This high forms the head of the formation and is
usually the highest point. Up until this stage, there is no indication that the
price will turn down.
Second Shoulder (Right): Prices start to fall again after the head and then
turn back up from the previous low to form a second peak. This peak is usually
near the level of the first shoulder and does NOT break through the highest
peak formed by the head.
Neckline: The line connecting the lowest points between the two shoulders is
called the neckline. Breaking this line indicates that the Head and Shoulders
formation is complete and a downtrend may begin.
How to trade this pattern?
Step 1 – Identify the Pattern Formation: One of the trickiest parts of
trading a head and shoulders pattern is identifying the pattern as it forms.
The shoulders may not be symmetrical, making it more difficult to spot the
pattern. There are two things to keep in mind when looking for a head and
shoulders pattern. First, these patterns require an existing uptrend. Without a
strong uptrend, there can be no head and shoulders pattern. Second, traders
should keep an eye on trading volume. In an ideal head and shoulders pattern,
volume will be highest as the left shoulder forms, lower as the head forms, and
lowest as the right shoulder forms. In addition, the volume should increase as
the left shoulder declines to the first trough and as the head declines to the
second trough.
Step 2 – Wait for the Breakdown: The breakdown at the end of a head and
shoulders pattern occurs when the neckline is broken. This breakdown should be
convincing, occurring on strong volume and coinciding with momentum indicators
pointing towards strong bearish momentum.
Step 3 – Enter a Trade: Once a breakdown is confirmed, traders can enter a
trade. Since a head and shoulders pattern predicts a bearish move, most traders
will short the target stock to profit from the breakdown. The expected size of
the breakdown can be estimated by measuring the distance from the top of the
head to the neckline directly below the head.
Step 4 – Take Profit: To determine the target price in the Head and Shoulders
pattern, the distance between the top of the head and the neckline is calculated
and this distance is added below the neckline. Thus, if the price triggers the
Head and Shoulders, the likely target is found.
Step 5- Stop Loss: It is also important to consider the possibility that the
formation may break down and remain a trap. You can minimize your losses by
placing the stop loss just above the neckline.
How can we confirm the pattern?
Several
different methods can be used to confirm the formation. One of them is volume
analysis – an increase in volume as the neckline is broken increases the
reliability of the formation. Or we can use technical indicators – indicators
such as the support of moving averages, the candle formation formed on the
neckline, and the rapid completion of the right shoulder can help confirm the
formation.
Inverse Head and Shoulders Pattern
It
is symmetrical to the head and shoulder formation. It appears at the end of a
downtrend.The first component of an
inverse head and shoulders pattern is a lead-in downtrend, which is a clear
downward trend in the price of the asset. This downtrend is typically
characterized by a series of lower lows and lower highs.
How to trade an inverse Head and
Shoulders Pattern
The
first step in trading an inverse head and shoulders pattern is to identify the
pattern. This involves looking for the lead-in downtrend, the inverse head and
shoulders formation, and the potential reversal breakout above the neckline
resistance. Candlestick patterns are
rarely as uniform as pictures often suggest, but formations should still be
visible to a practiced eye. If you see a low followed by a lower low (the left
shoulder and head), be on the lookout for that higher low (right shoulder) to
potentially catch the break out before it gets away from you. Waiting for the
breakout to confirm the bullish reversal can be the safer trade, but sometimes
entering while the right shoulder is forming offers the best risk-to-reward.
However, traders should always be cautious trading off of still-forming
patterns.
How to manage risk management on Head
and Shoulders?
The first and most important risk management step is to set the right
stop-loss level. The ideal stop-loss point in the pattern is above the neckline.
If the price goes back above the neckline after the formation is broken, it
means the formation is unsuccessful. In this case, closing your position is the
best approach to prevent further losses.
Setting a target price and taking profit when this target is reached is part of
disciplined risk management. In the formation, the target price is calculated
by measuring the distance between the head and neckline below the neckline
breakout. However, the exact target price may not always be reached. Therefore,
gradually reducing your position as you approach the target or using a trailing
stop can help you protect your profit.
And, it is important to get confirmation with other technical indicators to
increase the reliability of the pattern. By using additional tools such as
volume analysis, momentum indicators or trend indicators, you can increase the
chances of the pattern being successful and better manage your risk.
Is the Head and Shoulders pattern safe?
Although the Head and Shoulders formation is one of the most recognized and
used formations in technical analysis, it does not have absolute reliability,
as with every formation. The reliability of the formation may vary depending on
market conditions, time frame and other factors. The most powerful aspect of
the formation is that it is formed after a long uptrend and clearly signals a
trend change. Especially when supported by high trading volume, the formation’s
chance of success increases. However, not every formation in the market is
successful and in some cases it can produce false signals. One important point
to note is the mistake of entering the trade before the formation is fully
completed. Taking a position before the neckline is definitely broken means
acting prematurely, which usually results in a loss. It is important to be
patient and wait for confirmation signals for the formation to be completed.
Conclusion
The
Head and Shoulders pattern is one of the most reliable and widely recognized
reversal patterns in technical analysis. It signals a potential change in trend
direction, typically from bullish to bearish in its standard form, and from
bearish to bullish in its inverse variation. It consists of three peaks: a
higher central peak (head) flanked by two lower peaks (shoulders).
The
pattern is confirmed when the price breaks below the neckline (or above, in the
inverse case) with increased volume. Often used to anticipate reversals and
identify entry and exit points. Used correctly, the Head and Shoulders pattern
helps traders spot major turning points and improve their decision-making.
