How to trade the head and shoulders pattern?

The head and shoulders pattern is a popular reversal chart pattern that forms part of price action and technical analysis. Traders use it to predict future price movements.

This pattern is also known as a bearish reversal chart pattern, meaning that after the pattern has been completed, the market will generally change direction from a bullish (upward) market into a bearish (downward) market.

The pattern’s formation is unique. It includes three peaks—a left shoulder, a head, and a right shoulder—of different sizes with a neckline drawn using a trendline from where the price bounces off.

The market will generally start with a strong uptrend; at some point, the price will retrace and create the first peak or left shoulder. When the price moves up again, it creates another peak higher than the previous and retraces from there, known as the head. 

Lastly, when the price moves back up, it generally creates another peak at or lower than the first peak’s price point, known as the right shoulder.

The area where the price bounced off before creating the head and the right shoulder is known as the neckline, which could also be seen as a support level. Traders could draw a trendline, connecting those price points for a better visual representation.

Once the price has broken out below the neckline and the pattern has been completed, the price will likely reverse towards the downside.

It might be essential to remember that the formation of a head and shoulders pattern might not always be perfect; small price swings could occur within the pattern.

What does the head and shoulders pattern indicate?

A head and shoulders pattern indicates the uptrend has reached a point of exhaustion.

As the pattern starts forming with the first shoulder and the head, the price might seem to continue the uptrend. However, the formation of the second shoulder could indicate that the market has exhausted itself and that a reversal is on the way.

In other words, the buyers (bulls) were in control up until the formation of the head. However, sellers (bears) started coming in and overwhelming the buyers (bulls), which resulted in the price not moving higher but stopping below the previous high at or near the price point of the first shoulder before moving back down.

A head and shoulders pattern doesn’t only occur in bull markets; it can also appear in bear markets. The only difference is that the pattern’s formation is upside down, which is why it’s known as an inverse head and shoulders pattern.

This pattern signals a change in market direction, indicating the market is about to move from a bearish to a bullish market.

The market generally starts off with a strong downtrend, and at some point, the price will retrace upwards, creating the first trough or shoulder. As the price moves back down, it will move lower than the previous low (shoulder), creating the pattern’s head. After which, it retraces back up to confirm the neckline. 

Lastly, the price will move back down. However, it won’t go past the previous low (the head); instead, it will stop at or near the first shoulder’s price point, creating the second shoulder.

Again, traders could draw a trendline at the area where the price bounced off after creating the first shoulder and head to confirm the neckline, which can be seen as a resistance level.

Once the price breaks out above the neckline after the second shoulder’s formation, it could indicate the market has reversed into a bull market.

What does the inverse head and shoulders pattern indicate?

An inverse head and shoulders indicate the same thing as a standard head and shoulders, which shows the market has reached a point of exhaustion.

As the price forms the first shoulder, retraces, and forms the head, it might seem that the market will continue moving down. However, the formation of the second shoulder could be the first indication that the market has exhausted itself and a possible reversal is coming.

This essentially means that the sellers (bears) were in control up until the formation of the head. However, buyers (bulls) started coming in and overwhelmed the sellers, which resulted in the price not moving past that previous low (the head). Instead, it only reached the same or close to the first shoulders’ price point before rallying back up.

One of the essential aspects a trader might want to remember about trading a head and shoulders pattern is to wait for the pattern to complete itself before entering a position. 

The reason is that the market is unpredictable, and anything can happen during the pattern formation. For example, the pattern formation could be nearly complete, but just as the price approaches the neckline, it may reverse and continue the uptrend instead. This is why traders might want to demonstrate a certain level of patience when trading a head and shoulders pattern.

Once the pattern is completed, traders could enter a short (sell) position at the close of the candle that broke out below the neckline of a regular head and shoulders pattern, placing a stop-loss above the right shoulder with a take profit target at a distance equal to that of the neckline and head.

For an inverse head and shoulders pattern, the opposite is true; traders could open a long (buy) position at the close of the candle that broke out above the neckline, placing a stop-loss order below the right shoulder with a take profit target again at a distance equal to that of the head and neckline.

More conservative traders could wait for the price to retest the neckline after the price breaks out before entering a position. However, there might be a chance the price doesn’t retest the neckline and just moves in the direction of the new trend.

Other traders might use specific indicators, such as the Stochastic Oscillator or the Moving Average Convergence Divergence (MACD), to further confirm that a reversal is about to occur.

The head and shoulders pattern does have some unique advantages.

• Both patterns have clearly defined points where traders could enter a position after the formation has been completed.
• There are also clearly defined areas where a trader could place their stop-loss and take profit orders.
• The head and shoulders and inverse head and shoulders patterns aren’t confined to just one timeframe; this pattern can occur in any timeframe a trader might want to use, such as the 1 hour, 4 hours, daily, or weekly.

Both patterns could be used in various financial instruments, including stocks, forex, indices, and commodities.

While the head and shoulders pattern offers some advantages, traders might also need to consider some disadvantages.

• Both the head and shoulders and inverse head and shoulders pattern formation might not always be perfect, which could confuse some novice traders.
• If the patterns’ peaks or troughs are too large, this could result in a larger stop-loss placement, which could clash with a trader’s planned risk-to-reward ratio if they aren’t willing to take that big of a potential risk.
• As previously motioned, the price may not break out of the neckline even though the pattern has formed; instead, the price bounces off the neckline and continues to move in the overall trend.

The head and shoulders pattern could indicate a possible reversal is about to happen, either towards a downtrend or an uptrend, depending on the formation of the pattern. 

Before analysing a standard head and shoulders pattern and looking for potential trading opportunities, traders might want to remember that the market should be in an uptrend for this pattern to be considered valid.

The same goes for an inverse head and shoulders pattern; it should form while the market is in a downtrend before a trader could consider analysing it for a potential trading opportunity.

This is because, as previously mentioned, it’s a reversal pattern, which means that once the pattern is completed, the market should move from an uptrend to a downtrend or from a downtrend to an uptrend, depending on the dominant trend at the time and the type of head and shoulders pattern formed.

Now, both the standard head and shoulders pattern and the inverse head and shoulders pattern could provide helpful information for monitoring a position, such as placing a stop-loss order above the right shoulder with an expected profit target distance equal to the distance from the head to the neckline.

That said, the profit target placement is only an estimate because the price could not reach the same distance as the distance between the head and neckline, or it could go much further. A trader could use a trailing stop order instead of a regular stop-loss order to safeguard any potential profits if the price moves against them once it reaches a certain point.