How to trade the head and shoulders pattern? — Forex guide

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.

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.

What does the head and shoulders pattern indicate?

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.

What does the inverse head and shoulders pattern indicate?

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.

The opposite of this is applied in the case of 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. 

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.

Are all head and shoulders patterns equally as good?

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.