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Lesson 11: Head and Shoulders

Lesson 11: Head and Shoulders

It is not as easy to spot Head and Shoulders one would think because there needs to be a confirmation with a break below support or above resistance.

Head and Shoulders are chart patterns used to signify a reversal from the prevailing trend. Head and Shoulders patterns are highly effective when identified correctly. However, they can be extremely detrimental when they are interpreted incorrectly.

How to use this guide

To get the most out of this guide, it’s recommended to practice putting these Head and Shoulders trading strategies into action. The best risk-free way to test these strategies is with a demo account, which gives you access to our trading platform and $10,000 in virtual funds for you to practice with. Get your free demo account.

Once you’ve found a strategy that consistently delivers positive results, it’s time to upgrade to a fully funded live account where you can apply your newfound edge.

What is a Head and Shoulders Pattern?

A Head and Shoulders top reversal chart pattern form after an uptrend and its completion mark a trend reversal. The pattern contains three successive peaks, with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected to form support or a neckline.

As its name implies, the Head and Shoulders reversal pattern is made up of a left shoulder, a head, a right shoulder, and a neckline. Other parts playing a role in the pattern are volume, the breakout, price target and support turned resistance.

What is a Head and Shoulders Pattern?
Source: CAPEX.com
  • Prior Trend: It is important to establish the existence of a prior uptrend for this to be a reversal pattern. Without a prior uptrend to reverse, there cannot be a Head and Shoulders reversal pattern (or any reversal pattern for that matter).
  • Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder. The low of the decline usually remains above the trendline, keeping the uptrend intact.
  • Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline. The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy.
  • Right Shoulder: The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline.
  • Neckline: The neckline forms by connecting the low points. The first Low point marks the end of the left shoulder and the beginning of the head. The second low point marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal. The slope of the neckline will affect the pattern's degree of bearishness—a downward slope is more bearish than an upward slope. In some cases, multiple low points can be used to form the neckline.
  • Volume: As the Head and Shoulders pattern unfolds, volume plays an important role in confirmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing volume levels. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. Together, the decrease in volume and the new high of the head serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head, then decrease during the advance of the right shoulder. Final confirmation comes when volume further increases during the decline of the right shoulder.
  • Neckline Break: The head and shoulders pattern is not complete and the uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincing manner, with an expansion in volume.
  • Support Turned Resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break, and offer a second chance to sell.
  • Price Target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should be considered as well. These factors might include previous support levels, Fibonacci retracements, or long-term moving averages.

The head and shoulders pattern is one of the most common reversal formations. It is important to remember that it occurs after an uptrend and usually marks a major trend reversal when complete. While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. They can be different widths as well as different heights. Identification of neckline support and volume confirmation on the break can be the most critical factors. The support break indicates a new willingness to sell at lower prices. Lower prices combined with an increase in volume indicate an increase in supply. The combination can be lethal, and sometimes, there is no second chance to return to the support break. Measuring the expected length of the decline after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds over time, other aspects of the technical analysis pictures are likely to take precedence.

Inverse Head and Shoulders Patterns

The inverse head and shoulders pattern is used as an indicator. This pattern is associated with a reversal of a downward trend in price. It is one of the more common reversal indications. As the price progresses downward, it hits a low point (a trough) and then begins to recover and swing upward. Market resistance then pushes it back down into another trough.

Price drops to a point where the market cannot support lower prices and the price begins rising again. Again, market resistance forces the price back down, and the price drops one last time. If the market can't support a lower price, it doesn't reach the prior low. This causes a higher low before prices rise again. This movement creates three troughs, or low points, called the left shoulder, head, and right shoulder.

You will see two rallies or pullbacks occur during this pattern. One occurs after the left shoulder and one after the head. The high points of these pullbacks connect with a trendline, which extends out to the right. This trendline is called the neckline, or resistance line.

Head and Shoulders Inverse
Source: CAPEX.com

Since the inverse head and shoulders are a bottoming pattern when it completes you should focus on buying or taking long positions. The pattern completes when the asset's price rallies above the pattern's neckline or breaks through the resistance line.

On the pictured chart, the price rallies above the neckline following the right shoulder. Traders call this a breakout, and it signals a completion of the inverse head and shoulders.

Traditionally, you would trade the inverse head and shoulders by entering a long position when the price moves above the neckline. You would also place a stop-loss order (trade stop at a set point) just below the low point of the right shoulder.

The neckline works well as an entry point if the two retracements (the short intervals in the trend, or the smaller trough) in the pattern reached similar levels, or the second retracement hit slightly lower than the first.

If the right shoulder is higher than the first, the trendline will angle upwards, and therefore won't provide a good entry point (too high). In this case, buy or enter long when the price moves above the high of the second retracement (between the head and right shoulder).

Also, use this entry point if the second retracement high comes in much lower than the first. In other words, if the neckline trend gradually descends, use it as an entry point. If the neckline shows a steep angle, either up or down, use the high of the second retracement as an entry point.

How to Trade the Head and Shoulders pattern

There are two ways to trade using the head and shoulders patterns: you’d open a short position on a top head and shoulders and a long position on an inverse head and shoulders. Before you do either, however, it is important to confirm the signal with other technical indicators such as the stochastic oscillator or the MACD.

When you see the head and shoulders patterns and you want to place a trade, you can do so via derivatives such as CFDs. Derivatives enable you to trade rising as well as declining prices. So, depending on what you think will happen with the asset’s price when one of the head and shoulders patterns appear, you can open a long position or a short position.

Follow these steps to trade when you see the head and shoulders patterns:

  • Trading any type of chart pattern requires patience and the ability to wait for confirmation. The appearance of one of these patterns alerts traders of a price reversal, but until that occurs, most traders leave the pattern alone.
  • To get started trading head and shoulders patterns, open an account. Choose between a live account to trade CFDs straight away or practice first on our demo account with virtual funds.
  • Choose your financial instrument. Head and shoulders patterns can be spotted in most financial markets, especially those that are more volatile, such as forex, cryptocurrencies, and stocks.
  • Explore our online trading platform. We offer a wide range of technical indicators used to filter and confirm the head and shoulders patterns, as well as providing a range of order execution tools for fast trading, which in turn helps you to manage risk.

The below strategies for trading head and shoulders patterns are merely guidance and cannot be relied on for profit.

Trading the Head and Shoulders top pattern

Trading the Head and Shoulders top pattern
Source: CAPEX.com

The chart above shows a Head and Shoulders pattern example. The formation of the pattern is clear with the neckline highlighted by the dashed blue horizontal line. Traders will look to enter a short trade after a confirmation close below the neckline as seen by the ‘ENTRY’ label on the chart or the pip movement below the neckline. Some traders employ the ‘two-day’ close rule which necessitates a second confirmation candle closing below the neckline before opening the short trade. Trading on the pip break below the neckline allows traders to benefit from the full move down however, this tactic is riskier in that the breakout below the neckline has not been confirmed by a candlestick close.

There is a general rule of thumb to designate stop price and limit price. Taking the high point off the ‘right shoulder’ will specify the stop level whilst the vertical distance between the neckline and high of the ‘head’ will approximate the limit distance. The risk-reward ratio on this trade is roughly 1:1.2 which is still within the recommended risk management parameters.

Trading the Head and Shoulders Inverse Pattern

Trading the Head and Shoulders Inverse Pattern
Source: CAPEX.com

The Inverse Head and Shoulder pattern example shows an asymmetrical structure which is quite common in most formations. The neckline is slightly skewed, however, still maintains the integrity of the pattern.

The long entry level is highlighted by the neckline break or the price candle close above the neckline. The stop distance is taken from the low from the ‘right shoulder’ whilst the limit distance is calculated by measuring the distance from the ‘head’ low to the neckline.

Chart patterns provide price targets or an approximate area where the price could run based on the size of the pattern. You can subtract the low price of the head from the high price of the retracements. This gives you the height of the pattern.

For example, assuming you already know what forex is and how it works, if the low of the head is 1.2150, and the retracement high was 1.2110, the height of the pattern would equal four (1.2150 - 1.2110 = 40 pips).

Add the height to the breakout price to attain a profit target. If the breakout price was 1.2150, the target is 1.2190.

Price targets serve only as a guide in day trading, scalping, swing trading, or any trading style and technique; they offer no guarantee that the price will reach the target or that the price will stop rising near the target.

Confirming signals

Even when the market price breaches the neckline, it doesn't necessarily mean it's a lock to continue in that direction. To help confirm the trend, you should consider two more factors:

  • Volume: With a classic head-and-shoulders pattern, you'll see the trading volume start to lessen as the price moves higher toward the head and then again when it rebounds to form the right shoulder, indicating limited investor enthusiasm. A spike in volume, when the price moves below the neckline, suggests that selling pressure will remain intense. If neither of these volume signals is in play, the decline may be short-lived, though there are no guarantees.
  • Time frame: Profitable trend reversals require strong trends leading into them. One commonly used rule of thumb is that the uptrend heading into the pattern should be at least twice as long as the distance between the shoulders. This makes it more likely that any reversal of the trend will be significant enough to trade, and that rule of thumb applies whether you're looking at an intraday opportunity or a lengthier one.

Conclusion

Recognizing the Head and Shoulders patterns entail the exact same actions; making it a versatile tool to include in any trading strategy. The following list gives a simple breakdown of the key action points when identifying this pattern:

  1. Identify the overall market trend using price action and technical indicators (preceding uptrend)
  2. Isolate the Head and Shoulders chart construction
  3. The distance between the ‘Head’ and ‘Shoulders’ should be as close to equidistant as possible
  4. Delineate the neckline at the low point between both ‘shoulders’ – preferably horizontal but not obligatory

These steps are applicable to identifying both the standard and reverse head and shoulders patterns.

Focus on trading patterns that offer trades with a reward-to-risk ratio of greater than 2:1 even 3:1, based on the target and stop loss.

Therefore, the trade doesn't offer a very good reward-to-risk ratio, yet the pattern still shows a transition from a short-term downtrend to a short-term uptrend. Patterns where the right shoulder low hits well above the low of the head produce more favorable risk-to-reward ratios for trading.

Free trading tools and resources

Remember, you should have some trading experience and knowledge before you decide to trade chart patterns. You should consider using the educational resources we offer likeCAPEX Academyor ademo trading account. CAPEX Academy has lots of courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader.

Our demo account is a great place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how CFDs work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged trading.

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