No, we are not referring to the anti-dandruff brand here! The head and shoulder trading pattern is a fan favorite among chartists globally, given its simple identification and effectiveness.
Traders are consistently hunting for formations in the chaos that is the financial markets. Reversals can be quite profitable to trade. The head and shoulders chart pattern is a straightforward method of exploiting these to increase your equity curve.
Thomas Bulkowski is said to have analyzed about 430 head and shoulder stock patterns on the daily charts from 1991 to 1996. Here, he concluded that it worked 93% of the time, where the average price decrease was 23%.
This demonstrates how this pattern has stood the test of time among the likes of the double top/double bottom, triangle, flag and Doji star. So, let’s explore the head and shoulders formation in more detail so you can trade successfully with it.
We’ll describe how it materialises, the strict rules, and real-life examples of the pattern in action.
What is a head and shoulders pattern?
The head and shoulder pattern is formed by three consecutive peaks, where one is higher than the two of adjacent heights. The last element of the set-up is the ‘neckline,’ an area at which traders expect the price to break out, confirming the reversal.
Below is a simple graphic illustration of the bearish and bullish (or inverse) head and shoulders patterns for better understanding.
The ordinary or bearish head & shoulder pattern happens during an uptrend, while the inverse version occurs during a downtrend. In the first scenario, the price would rise to a high, declining back to a base or support level.
It then rises higher than the first high to form the ‘head,’ retracing down to the original base. This would, of course, later become the ‘neckline.’ Lastly, the market peaks again, but, this time, to about the height as the first high.
If the price declines from this point toward the neckline level, this completes the head and shoulder formation.
The opposite is true when observing this set-up’s inverse or bullish version. It’s worth noting that the head shoulder pattern can have a diagonal neckline, as in the image below:
Whether this area is horizontal or diagonal, the pattern will be valid once it meets the other criteria. We will go through both examples later in our head and shoulders technical analysis.
So, what makes this set-up so effective? The key element of any reversal formation is reliability. The head and shoulders pattern’s reliability is in how long it takes to appear, especially in higher time frames.
Time is one of a trader’s greatest allies. A market generally takes a while to go into reversal mode. Too often, many traders jump at the first sign of a trend change, which is often a false signal.
On the other hand, the build-up with the head and shoulders pattern is steady and is usually an effective conclusion for a true reversal. The neckline area is a conservative entry spot.
The second advantage is that this set-up is easy to spot on the charts. You can use it across all financial markets like forex, crypto, options, metals, and many others. This formation also has clear identification rules coupled with defined entry and exit rules.
What does a head and shoulders pattern mean?
Any chart pattern merely reflects mass psychology or behaviour, describing how buyers and sellers react. The head and shoulders pattern is an intriguing arrangement of a reversal occurring in various stages.
Let’s look at the bearish or standard version of the set-up. Here, the price is moving nicely in an uptrend, making higher highs and higher lows. At this point, the left shoulder (the second-to-last high) forms.
Despite the pullback, there is no indication that the bulls (buyers) have lost steam. The price continues to produce a higher high, which becomes the ‘head’ of the head and shoulders pattern.
Again, we see another retracement towards the previous pullback zone (neckline), where it gets interesting. The sentiment here would still be bullish, as the bulls expect the price to surpass the the ‘head.’
Yet, these are the ‘latecomers’ of the trend. Fewer buyers are willing to buy at this stage because it is an overpriced area. Despite this, the remaining bulls will try to push the price. However, the market will only go as high as the left shoulder before the bears (sellers) start coming in.
There is a lot of fear here, as bulls turn to bears or quickly run away with any profits up to this level. Eventually, unbeknownst to any hopeful buyers, a sell-off begins. The neckline or support level acts as a confirmation of the breakout to the downside.
This is the vital level when trading the head and shoulders pattern because it’s where you should enter.
Head and shoulders pattern rules
Although trading head and shoulders is relatively easy, the pattern does take a while to fully materalise, depending on the time frame. Like most patterns, you can use an indicator or manually draw it.
Indicators or scanners are not always the best option, so many chartists prefer the manual approach due to its flexibility. However, you will only need to map out the formation once it reaches the second shoulder.
Once the market has created the second shoulder, you must confirm:
- The left (1) and right shoulder head (3) are relatively the same height (but not exactly).
- The head (3) is higher than (1) and (2).
Once these three points exist, you can connect the dots and apply the neckline. You’ll want to ensure it is applied at the absolute price lows of the (1) or (3) legs.
Identification is the first of head and shoulders pattern rules. Let’s get to the next crucial elements: the entry and exits.
Entry and exits
You can use two methods to enter the head shoulders pattern, both of which are conservative. Generally, most traders will execute as soon as the price touches the neckline, as demonstrated in the previous image.
Of course, this is the whole aim of the entire formation. Yet, like all breakout strategies, false breakouts can happen anytime.
So, the first technique is to look for a closed bearish Maribozu, a full-bodied candle with little to no wick. This suggests strong selling force and decreases the likelihood of a false break. It’s essential to wait until such a candle pattern has closed fully, depending on the time frame reference.
The second approach is also conservative, although you might miss a few head and shoulder trading set-ups. Here, you will wait for the price to retrace slightly beyond the neckline using the Fibonacci tool, offering you a better entry, tighter stop, and potentially greater reward.
The only downside is that you might miss the opportunity if the market breaks out violently without retesting the neckline. An extra tip is to enter mid-level from the neckline and second shoulder.
In the next section, we’ll discuss both techniques in more detail for better illustration.
Let’s now look at the stop loss (SL) and take-profit (TP) parameters for the head & shoulders pattern.
As in the above image, you should place your SL at the right-side high (or low of the right shoulder for the inverse pattern).
The minimum profit target is the distance from the head to the neckline. Of course, this is a general rule of thumb; it doesn’t guarantee the price will always travel this distance. There will be times when it does, goes further or only partially. Therefore, you should prepare yourself for either scenario.
Chart examples demonstrating head and shoulders pattern trading
So, we’ve got the admin stuff out of the way. With real-life chart examples, let’s explore the head and shoulders pattern in action.
The first is an inverse head and shoulders trade on the 1HR chart of NZD/USD.
Here, we have a slanted neckline. We see a bullish Marubozu that breaks the neckline. The candle after this produced a low at the neckline. Here, you could have used the second entry technique of waiting for the retest.
Furthermore, the market traveled about 131 pips from the neckline, greater than the 111-pip distance from the neckline to the head.
Let’s look at the second example of the stock head and shoulders pattern on the weekly chart of UltraTech Cement.
What is different about this from the first illustration is this market offered two entry opportunities. The callout marked ‘1’ shows how you could have gone short after waiting for the neckline rest.
The callout with ‘2’ shows a second entry chance as the price returned with more pressure to break the support. Like the first example, the market travelled the minimum profit target of the head & shoulders pattern.
Our last demonstration is on the 4HR chart of the EUR/GBP pair, an interesting case of a false break scenario where the ‘midway entry’ would have worked.
We can see three candles of similar body and wick depth failing to break the neckline. The price then retraced about midway of the right high, a perfect area to area as described earlier.
We can observe the market again attempting to push beyond the neckline before a pullback to a similar spot. Finally, it generated enough selling pressure to complete the head and shoulder formation.
This back-and-forth price action is common with higher time frames. The key is being patient and ensuring your stop is in the right place for the move.
Like the last two examples, the price moved the expected profit target.
Conclusion: pros and cons of the head and shoulders pattern
There you have it! Consider this article a sufficient guide to trading this interesting set-up. Let’s briefly summarise the good and bad of the head and shoulders pattern before you plan to make money with it.
- Relatively simple to identify
- Works across all time frames and markets
- Has clear entry, stop loss, and profit-taking rules
- Proven accuracy
- Conservative entry for a reversal
- Usually requires a larger stop distance, resulting in a lower risk to reward ratio
- Takes time to form, especially on higher time-frames
- Can still fail to generate a reversal