At the end of the day, it’s important to stick with trades that respect your risk tolerance and help you achieve your trading goals. The head and shoulders pattern has been historically shown to be a fairly reliable one in a space that is characteristically unpredictable. It’s also one of the most easily recognizable chart patterns. Many traders will unknowingly trade the beginning of a head and shoulders pattern as something else.
This pattern develops after an extensive bearish trend and represents the transfer of control from bears to the bulls. Like the topping pattern, here bulls are using the breakdown as an opportunity to go long at lower prices. It could also give longer term bears the liquidity to cover their positions. Traders like to trade head and shoulders formations as the price targets are very predictable and the formation has an overall high success rate. For more on trading chart patterns and other forex trading strategies, check out my Forex Trading Strategies Guide for Day and Swing Traders .
Because of this, we’re only going to focus on the second approach. But even when waiting for the market to close below the neckline there are two entry methods to consider. By doing this, you mitigate the risk of having the market snap back on your position and stop you out for a loss.
Not only does it represent the support level that governs the price breakout, but also it can signal the aggressiveness of that breakout. Necklines tend to slope up or down slightly; ascending necklines are more reliable and often more aggressive. The chart formation of the Head and Shoulders pattern is one of the most reliable to predict the reversal in the market trend from bullish to bearish.
When the asset fails to break the previous low price, it can mean that the asset’s price is heading higher, and the pattern has failed. There is frequently a correction back to the neckline, which then acts as a support level. Go long on a reversal signal and place a stop-loss one tick below the support level. The extent of the breakout move can be estimated by measuring from the top of the middle peak down to the neckline.
We will now use the same two examples to give you a step-by-step guide on how to trade the head and shoulders and inverse head and shoulders patterns. This is a NZD/USD daily chart where the sellers are pressing the price lower, creating a series of lows. The head is represented by a series of similar lows, while the two shoulders are sitting on each side of the head.
#3 The Right Shoulder
The second method involves the difference between the neckline directly above the head and the low of the head. If you look at #2 marked on the chart, you’ll see an example of a pullback. Pullbacks are entirely normal and expected behavior in almost every chart pattern that exists. Volume is highest on the left shoulders and then falls into the right shoulder. Patterns that have volume dropping on the right shoulder have a high probability of becoming profitable.
As a general rule, the longer the uptrend lasts, the more substantial the reversal is likely to be. However, we need both shoulders and the head of the pattern before we can identify the neckline. It will make more sense as you progress through the lesson.
That’s what you want to see when trading any bearish reversal pattern. It has formed the left shoulder, the head is still in formation. The drop to the neckline might be substantial, from top of the to bottom of the head.
Although the price action completes the minimum target of the pattern in just three periods, the trade could be held further since the AUD/USD momentum was sharply downwards. This short Head and Shoulders trade could be held until the price action breaks the yellow bearish trend line in the bullish direction. This is the first indication of a reversal potential and an emerging Head and Shoulders reversal pattern on the chart.
If this plays out, we can see a deeper correction that will flush out all the retail traders with high leverage. This type of Head and Shoulders pattern has more than one left and/or right shoulders and/or head. Most of the head and shoulders trading time Head and Shoulders are not perfectly shaped. However, there are trade management techniques where you can lock in some of your profits and still keep your trade open in case the price continues to move your way.
Multiple Ways To Trade The Head And Shoulders Chart Pattern
Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. When executing an inverse head and shoulders pattern, a stop loss order should be placed slightly below the neckline in anticipation of the breakout. For those who want to place a more aggressive trade, they can enter their stop loss order at the bottom of the right shoulders of the inverse head and shoulders pattern.
- We explain the difference between Head and Shoulders patterns and Reverse Head and Shoulders patterns, along with the components of the pattern as seen on a chart.
- Go short on a reversal signal and place a stop-loss one tick above the resistance level.
- The limitation of the second option is that the price action can simply resume lower without performing a throwback i.e. a retest of the neckline is not guaranteed .
- As you can see, the stock rose to $140 and then pulled back to $93.
- The price rallies again, creating a higher peak, which is known as the peak of the head.
You should always remember that the head and shoulders pattern is not always validated. If a significant move up on high volume takes place during the verification phase, the whole pattern might be invalidated. This was ultimately the case in the example from our previous chart. It occurs when the price of an asset reaches a new top and retraces afterwards (in our mining stocks example the left shoulder was completed in mid-March).
Learn To Trade
The others are a double or triple top, hammer, bullish and bearish engulfing, doji, and a rising and falling wedge pattern. After the formation is completed, there is a reasonable probability, Credit default swap that the price will continue falling. Upswings would probably be short-lived and serve as a verification of the H&S pattern and as a test of the new resistance level .
It doesn’t matter that you drew a perfect head and shoulders pattern, if there is no prior uptrend or downtrend as both versions are reversal patterns. It also makes it easy for traders to place stop-loss orders. In the case of a peaking head and shoulders pattern, stops are typically placed above the top-of-the-head high price. With an inverse head and shoulders pattern, stops are usually placed below the low price formed by the head pattern. Head and shoulders patterns can also form in the opposite direction, signaling a market reversal and trend change from bearish to bullish.
How To Interpret Head And Shoulders Pattern
Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7 & 63 licenses. He currently researches and teaches at the Hebrew University in Jerusalem.
New Here? Not Sure Where Your Financial Journey Should Be Headed?
The image illustrates a Head and Shoulders trading example. The Head and Shoulders neckline is considered the most important component in trading the H&S pattern. The reason for this is that the H&S neckline acts as the trigger line for trading the pattern.
Look back to the long-term chart where the head and shoulders pattern is forming. A reverse head and shoulders is a bearish to bullish reversal pattern. Like I said before, the head and shoulders pattern is a bullish to bearish reversal pattern. Alternately, some traders will hold out longer for their entry, with a reversal back into the neckline after an initial breakdown providing that sell signal.
Prices rise again but don’t last long and the bearish trend pushes the prices downward again. Chart pattern recognition is one of the most popular techniques to trading the forex market. There are many different types of chart formations that a trader can study and incorporate into their setup arsenal.
What Is The Inverse Head And Shoulders Pattern?
The pattern appears on all time frames and can, therefore, be used by all types of traders and investors. Entry levels, stop levels, and price targets make the formation easy to implement, as the chart pattern provides important and easily visible levels. The first two dips Super profitability appear to be part of the bearish trend. Just like the regular head and shoulders, it’s the third dip that completes the pattern and confirms the trend reversal. The first and third troughs are considered inverted shoulders, while the second is regarded as the inverted head.
When Should You Collect Profits?
In its final act, the price rises once more to near the level of the left shoulder before it declines again for a final time. The DAL chart above is a perfect example — both shoulders top out at the same level just below $60. You can learn to use 15+ trading strategies including Statistical Arbitrage, Machine Learning, Quantitative techniques, and Options pricing models and more. This learning track is perfect for traders and quants who want to learn and use Python in trading.
This drop in prices is not for long when the bullish trend makes a comeback and the prices escalate reaching new higher levels. Price starts dropping again after reaching the highest level, marking the bearish trend. The prices rise again when the bullish trend makes another comeback. Head and shoulders tops and bottoms are reversal chart patterns, which can develop at the end of bullish or bearish trends.
Author: Annie Nova