11 March 2024 - 6min Read

Trading patterns

Head and shoulders pattern

Traders and analysts study trends and patterns while observing the market to help them predict future price movements. Identifying and interpreting patterns are integral elements of effective trading. Many traders consider the head and shoulders pattern to be a reliable indicator in predicting the direction of future price movements. 

In this article, we’ll examine this pattern in detail, discussing its significance and how you might benefit from it.

TABLE OF CONTENTS

Key takeaways

  • A head and shoulders pattern is a  trading pattern with three peaks on a chart, the outside two being near in height and the centre peak being the highest.
  • A head and shoulders pattern is considered a reliable forecast for a trend reversal.
  • On the other hand, a bearish-to-bullish trend is predicted by an inverse head and shoulders pattern.
  • Depending on the pattern orientation, the neckline represents the support or resistance.
  • The peaks on either side are the left and right shoulders, while the one in the centre is the head.
  • The head and shoulders pattern is thought to be one of the most dependable trend reversal patterns, although it is not without limits.

Marc Aucamp

Content Writer

Liked this article? Share now on socials

What is the head and shoulders pattern?

The head and shoulders pattern is a reversal pattern. The formation is known as head and shoulders because it resembles a neckline with three peaks, with the central peak being the tallest. As a result, the three tops resemble a "left shoulder," "head," and "right shoulder."

The standard head and shoulders configuration and the inverse head and shoulders formation are both reversal patterns. Both have three required components:

Head - In the standard head and shoulders pattern, the head must be higher than the two shoulders. In a reverse head and shoulders, the head must be lower than the two shoulders. 

Shoulders - In the standard head and shoulders, the left and right shoulders are two tops on either side of the central peak. They should ideally be symmetrical, that is, peaking at or near the same price level. Asymmetrical shoulders are commonly tolerated as long as the space between two peaks is not too great. With the inverse version, the left and right-hand side dips should also reverse at, or close to, a similar price level. 

Neckline -  With the standard head and shoulders, the neckline is a horizontal or trend line that joins the bottoms of the two shoulders or the tops of the two shoulders when considering an inverse.  It is perhaps the pattern's most essential characteristic since it is a break through the neckline that triggers the pattern.

Head and shoulder pattern in trading

A head and shoulders pattern shows that the uptrend has exhausted itself and the reversal has begun when the succession of higher highs (the first and second peaks) is broken by the third peak, which is lower than the head.

The image above shows the conventional formation marking the end of an uptrend and the start of the decline.

What is the inverse head and shoulders pattern?

The inverse head and shoulders is a bullish reversal pattern that happens towards the conclusion of a downtrend. It shows that the sellers have run out of steam and have been unable to drive the market any lower. The third low (the right shoulder) is higher than the lowest low of the trend.

The inverse head and shoulders pattern

After the formation of the first low (the left shoulder), the price action marginally recovers before going down to form an even lower low (the head). The price subsequently recovers to a level comparable to where the initial rebound ended, forming a foundation for the neckline to be drawn.

The price action then pulls back to form a third low (the right shoulder) before eventually breaking above the neckline and generating the inverted head and shoulders pattern.

How to trade the head and shoulders pattern?

The entry opportunity arises when the price breaches the neckline once the head and shoulder pattern has formed.   Make sure that you instigate a suitable risk management plan when selecting entry and exit points on a price chart. 

In the regular head and shoulders pattern, the stop-loss order is normally put above the right shoulder, whereas in an inverse pattern the stop is placed below the right shoulder. For both the standard and inverse patterns, the take profit is typically placed at a distance equal to the distance between the neckline and the head.

Trading using the head and shoulders pattern

The opposite of this is applied in the case of the inverse head and shoulders pattern.

Trading using the inverse head and shoulders pattern

Pros and cons of head and shoulders pattern

Both variants of the pattern have the same strengths and limitations. The head and shoulders pattern has the benefit of defining obvious zones to establish risk and reward.

The pattern clearly defines where stop loss, take profit, and entry levels should be set. However, you should never enter a trade unless there is a clear breakout below or above the neckline. 

The fundamental drawback of the head and shoulders pattern is that a strong trend may force price to continue moving in the same direction despite the formation of the third shoulder. This is why it is important to wait for the price to make a significant break through the neckline.

The markets are moving.

Start trading now.

Get startedarrow-icon
arrow-icon

Does the head and shoulders pattern really work?

The head and shoulders pattern may indicate the end of an uptrend or downturn, but you should wait for the price to break through the neckline before taking action. But once this happens, the pattern then provides a useful framework for monitoring the resulting trade. Measuring the pattern's height or depth for an expected profit target, the right shoulder for stop loss placement, and the neckline for entry.

Like any sophisticated technical analysis patterns, trading head and shoulders chart patterns have advantages and disadvantages. The profit objective is an estimate, which means that the price may go not only that far but also much farther. It may be wise to set up a trailing stop to take advantage of such a move. 

Some traders may choose to concentrate on patterns with specific characteristics. A tiny right shoulder, for example, has a lower stop loss than a huge right shoulder, while the profit estimate is based on the whole height of the pattern. In this case, the stop loss is much smaller than the profit target providing a better risk-to-reward ratio.

Final thoughts

Not all head and shoulder patterns are created equal, and it should be emphasised that their profitability depends on the market conditions. The head and shoulders pattern is also one of the most frequently identified chart patterns. No chart pattern is 100% accurate, but it can provide a good risk-to-reward ratio. Finally, respecting a risk tolerance that helps you realise your trading objectives is critical.


People also asked

/

The head and shoulders pattern is a reversal pattern in which the market reverses after making a top in an uptrend or a bottom in a downtrend. Its shape resembles a head and shoulders.

/

The presence of a well-formed head and shoulders pattern stands out. The standard head and shoulders suggest that buying interest is fading, while the inverse pattern shows that downside momentum is reduced.

/

A head and shoulders pattern's neckline joins the lows from both shoulders. It is the structure's "trigger line." A breakout below or above it indicates that a price reversal may be coming.

/

It should ideally develop after a long bull or bear run.

Suggested articles

See allarrow-icon
arrow-icon

Gain the edge

Sign up and unlock early
access to exclusive trading
insights and educational tips.

I confirm I am 18 years old or above.

By signing up to hear from us, you agree to our terms and privacy policy.

Please keep me updated on Trade Nation’s sponsorships, news, events and offers.

The markets are moving.

Start trading now.

Get startedarrow-icon
arrow-icon

Trade on our
award-winning
platform


en-au

Payment methods

Visa card payment method
Mastercard payment method
Helloclever payment method
Apple pay payment method
Skrill payment method
Westpac payment method

Trade on

Regulatory bodies

UK - FCA

Australia - ASIC

Seychelles - FSA

Bahamas - SCB

South Africa - FSCA

Customer support

Sponsors of your favourite teams

The legal stuff

Contract for differences are complex financial instruments that requires knowledge and understating as it involves a high risk of losing money rapidly due to leverage. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. This information is general advice only and does not take into consideration your objectives or financial means. Refer to our legal documents.

Trade Nation is a trading name of Trade Nation Financial UK Ltd, a financial services company registered in England & Wales under company number 07073413, is authorised and regulated by the Financial Conduct Authority under firm reference number 525164. Our registered office is 14 Bonhill Street, London, EC2A 4BX, United Kingdom.

Trade Nation is a trading name of Trade Nation Australia Pty Ltd, a financial services company registered in Australia under number ACN 158 065 635, is authorised and regulated by the Australian Securities and Investments Commission (ASIC), with licence number AFSL 422661. Our registered office is Level 17, 123 Pitt Street, Sydney, NSW 2000, Australia.

Trade Nation is a trading name of Trade Nation Ltd, a financial services company registered in the Bahamas under number 203493 B, is authorised and regulated by the Securities Commission of the Bahamas (SCB), with licence number SIA-F216. Our registered office is No. 3 Bayside Executive Park, West Bay Street & Blake Road, Nassau, New Providence, The Bahamas.

Trade Nation is a trading name of Trade Nation Financial Markets Ltd, a financial services company registered in the Seychelles under number 810589-1, is authorised and regulated by the Financial Services Authority of Seychelles (FSA) with licence number SD150. Our registered office is CT House, Office 6B, Providence, Mahe, Seychelles.

Trade Nation is a trading name of Trade Nation Financial (Pty) Ltd, a financial services company registered in South Africa under number 2018 / 418755 / 07, is authorised and regulated by the Financial Sector Conduct Authority (FSCA), with licence number 49846. Our registered office is 19 9th Street, Houghton Estate, Johannesburg, Gauteng, 2198 South Africa. 

The information on this site is not directed at residents of the United States or any particular country outside the UK, Australia, South Africa, The Bahamas or Seychelles and is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.

© 2019-2024 Trade Nation. All Rights Reserved