Head and Shoulders pattern guide (PDF)

Head and shoulders pattern is a type of chart pattern, and it is among the most known graphical patterns. It can be utilized to identify and trade reversals. The name of the pattern obviously describes its graphical form. However, it consists of three successive tops. Two extreme tops which called shoulders and middle top which called head. Also, there is a line connecting the bottom between the pattern tops called the neckline. there is another form of this pattern which is the inverse head and shoulders pattern. And as its name said, it is simply the inverse of head and shoulders pattern. in this course, we will explain what is it, how it works, how to draw it, and how to trade it.

What Is the Head and Shoulders Pattern?

Head and shoulders pattern is a forecasting chart formation that tells about a potential reversal in the market. That is why we call it a reversal trading pattern. Moreover, it is generally seen when the price of a security is in an uptrend. Besides, it is considered to be the most reliable trend reversal pattern and among the top patterns that signal with varying degrees of precision that an uptrend is nearing an end.

This pattern emerges with a baseline called neckline and three peaks. As its name suggests, it draws a picture of how a person looks like. Therefore, the first peak, which corresponds to the left shoulder, and the third peak, which corresponds to the right shoulder, are close in height. And the middle peak, which is the head, is usually the highest. And this is nature, as the head of a person is higher level than their shoulders.

How to identify head and shoulders pattern ?

you need to know how the head and shoulders pattern is created to understand it better. This will summarize what is drawn in the image above:

The prior trend: To form a head and shoulders pattern, it must be an initial uptrend for the price movement. if this condition is not available the pattern cannot form.
Left shoulder: This represents the first peak in the pattern. After this peak, a decline occurs to complete the construction of the shoulder. It takes place when traders who push the price higher lose their enthusiasm temporarily.
Head: After the first downtrend, the price rise again. The rise stays for a while and exceeds the peak of the left shoulder. After peaking, the price declines at or near the prior low. Which will mark the second point of the neckline.

Right shoulder: After the second downtrend, the price rises again and forms the third peak, which reaches a lower level than the head (previous peak), but generally at the same height as the left shoulder.
Neckline: It is a line connecting the two low points. The first low point denotes the end of the left shoulder and the beginning of the head. And the second low point denotes the end of the head and the beginning of the right shoulder. However, the neckline can slope up, down, or even can be horizontal, which depends on the relationship between the low points.

Volume: volume plays a crucial role in head and shoulders pattern. It is used as a confirmation signal. Therefore changes in volume indicate whether the pattern is forming or not. Ideally, at the formation of the left shoulder, the volume should be higher than during the formation of the head. Moreover, the decline in volume and the new high of the head together act as an alert sign. And the second alert sign happens when the volume rises and at the same time there is a decline from the peak of the head, then drops when the right shoulder begins to form. The final confirmation occurs when the volume increases more during the drop of the right shoulder.
Neckline breaking: to consider the head and shoulders pattern completed, the neckline must break. After the break of the neckline trend will reverse and signals an increase in volume.

Inverse head and shoulders pattern example

Inverse head and shoulders pattern is simply the opposite of the standard pattern. It happens in a downtrend direction, when the price moves lower. Moreover, it forms valleys instead of peaks. The left shoulder forms when the price of the security falls and then rises. after that, it comes the head, which formed when the price falls again and exceeds the prior trough, then rises. And lastly, the right shoulder forms when the price falls at the same level as the first trough, then rises. These swing highs following the left shoulder and the head, form the neckline. The last rise of the left shoulder can break the neckline and move beyond it. Therefore the price is likely to continue increasing.

Bullish vs bearish pattern

The head and shoulders pattern is a bearish pattern. This means that when the pattern forms, it signals that the bullish price move will soon shift bearish. In more detail, when the market is in an uptrend for a while, and the head and shoulders pattern forms, that may indicate that the present trend may turn now to a downtrend. In this case, you should exit your long position and enter a short position.
Inverse head and shoulders chart pattern is a bullish pattern. This means that when it forms after a bearish trend, it signals that the bearish price move will soon turn bullish. In more detail, when the market is in a downtrend, and you see the pattern form, that may indicate that the current trend may turn from the downtrend to the uptrend. here, you should exit your current short position and enter a long position.

How to draw head and shoulders pattern ?

The Head and shoulders pattern is very easy to draw. Therefore you need to follow the following steps to learn how to draw it:

Look at the chart of the security you are trading, and check the level that it is in.
You should find the head and shoulders pattern in the chart. This means that you should find a left shoulder, a head, and a right shoulder that follow the rules mentioned earlier.
Draw the pattern using the tool available on your platform, then draw the neckline that collects the low points.
keep watching the right shoulder, and see whether it breaks the neckline or not. If it breaks the trendline this indicates that the trend will continue to drop. And if it moves back, you should look where it reaches.

How do the head and shoulders work?

Head and shoulders pattern is like all the other chart patterns. The ups and downs of the pattern show the battle between the bears and bulls. However, the first peak and the following decline represent the waning strength of the previous bullish trend. Bulls rebound to push the price back up above the first peak to reach a new high because they want to keep the uptrend as long as possible. At this level, it is still possible that bulls can reinstate their domination in the market and continue the uptrend.

In addition, once the price drops a second time and reaches a level below the second peak, this means that bears are gaining ground. Then bulls try one more time to drive the price up but they only succeed to reach a level lower than the second peak. Therefore, this failure to exceed the highest high, signals the defeat of bulls and the success of the bears. This leads to falling in the price and completing the reversal.

How to trade head and shoulders pattern ?

Before making trades, you should wait for the head and shoulders pattern to complete, because trading an incomplete pattern can be risky as the pattern might not develop at all or partially developed might not be complete in the future. Therefore, you should not assume that it will be completely developed and make trading decision based on what you anticipate is going to happen. But you should wait until the pattern breaks the neckline to enter a trade. However, when trading the head and shoulders pattern you should wait for the price to move lower than the neckline after the third peak. Moreover, when trading the inverse head and shoulders, you should wait for the price to move above the neckline after the formation of the right shoulder.

While you are waiting for the price to break the neckline, you can prepare for a trade. However, you can write down the entry, the stop loss, and the profit target. as well as any other variables that can affect your profit and stop targets.

Placing entry point:

You can enter the trade with two different methods. The first method consists of entering a short position once the neckline is broken. This is the most common method. Besides, the second method is more complex and requires patience. It involves waiting for prices to retrace to the neckline or just above after the breakout has happened. This is more conservative as it provides traders with the opportunity to enter the trade with a more favorable price. But you can miss a trading opportunity, while you are waiting for a retracement that never develops.

Placing Stop loss:

In the standard market top pattern, the stops are put just above the right shoulder after the neckline is pierced. However, you can use the head of the pattern as a stop, but this is can be very risky as reduces the risk-reward ratio of the pattern. In the inverse head and shoulders pattern, the stop is put just below the right shoulder. And you can also put it at the head of the pattern, and as we said earlier this exposes you to a larger risk.

Placing profit target:

The profit target is the difference in price between the head and the low point of one of the shoulders. Then you subtract the difference obtained from the neckline breakout price to deliver a price target to the downward side. In the reversed pattern you add the difference to the neckline breakout level to deliver a price target to the downward side.

Conclusion

The head and shoulders chart pattern is the most reliable pattern and it is common among chartists. It is very easy to trade with and recognize. This pattern is very helpful for identifying reversal and you can use it in different markets and in all time frames. When you find the head and shoulders pattern completed, you can use it to set entry points, stop loss, and profit targets. This is why it is very poppular.

May 15, 2023