Head and shoulders (H&S) pattern refers to the technical formation in charts. Different types of this pattern are quite common; however, the pattern is rarely seen in its pure form. There are two version of this formation — standard Head and shoulders pattern and the inverted version (IH&S). The key part to be remembered for the H&S patterns is that they are reversal patterns i.e. we are looking for a change in trend.
Before reading the article and writing your questions in comments section, I recommend to watch this video. It’s not long, but covers biggest part of questions on the topic.
Elements of Head and Shoulders pattern
Head and Shoulders pattern is based on the three key elements. Standard H&S pattern happens after an uptrend during which the price rises to a peak and subsequently declines to form a trough.
Second part of the formation is when the price rises again to form a second high substantially above the first high but declines again. The price raises a third time, but only to the level, or close, of the first peak, before declining once more and consequently breaks the neck line (Picture 1). Inverted version has the same steps but only the other way around i.e. we are forming a bottom and looking for a rebound.
This pattern’s feature is the average peak will be above the right and left. As you might guess, the head is the average peak (the highest one). The shoulders are the right and left lower swings high. Two cavities, which are located between the shoulders and the head, form the neck line of this pattern. This level is very important, since it is a signal to enter a trade. The biggest trap that this formation creates is to enter into a trade before the neckline is broken.
When to enter into trade ?
Trades based on technical analysis require traders to strictly adhere to the rules i.e. signal given by the respective formation. Unfortunately, not all traders follow signals and instructions, hence results are errors which lead to losses in trading.
Activated head and shoulders pattern makes two signals:
- after the neck line is broken and
- when the price re-tests the neck line that now acts as resistance (previous support).
Many traders enter into trade while the price is still in the right shoulder part of the formation. However, the neckline will still act as a support. Hence, the first signal appears after break of the neckline as it is seen in the Picture 2.
The second signal is when the price tests the neck level from the bottom in the context of resistance. In this case, it is recommended to wait for the moment when a price rebounds to the neck line, enter the short trade and place your stops above the neck line.
Inverted Head and Shoulders Pattern
As it was mentioned above, there is a mirror model of the same pattern which allows trading the same formation on the other side of the chart. This model consists of the same components — head and two shoulders.
Unlike the standard pattern, the inverted one is formed by the lower extremums, i.e. by market depressions, not by the upper extremums. The head is formed by the swing low while two shoulders minimums will be a bit higher (Picture 3).
The neck line, unlike the standard model, will play the resistance role, but not the support one. But this does not change the pattern in essence. Again, it is recommended to wait for the moment when the price breaks the resistance level after the second shoulder formation before entering a trade.
Technical analysis is self-sufficient. This means that the probability of working out any pattern is high, provided that the rules for its formation are respected. However, there are additional tools which can help when the signals appear.
In particular, they include volumes. This indicator plays a very important role in the model formation and during the signal processing. The volumes drop when the price moves from the left shoulder to the head peak indicates that buyers are not in control of the situation anymore. The volumes growth when moving from the head peak to the right shoulder indicates the growing strength of the sellers.
Finally, when the price reaches the peak of the right shoulder and starts to decline, the volumes may increase substantially until the support intersects (or resistance, if the inverted head and shoulders patterns).
It is also possible to confirm this model with the help of various indicators, as well as candlestick analysis. Trend indicators will indicate a trend reversal even before the signal emergence. The same can be done by the oscillators, which, most likely, will leave the overbought or oversold zone (the second, if it is an inverted pattern).
Measuring take profit
In the trading business, it is very important both to find the moment of entry and to determine the stop and target levels when closing positions. In this particular case, the H&S formation offers a pretty clear way to measure both take profit and stop loss.
Usually, after a neckline breakthrough, the price runs a distance equal to the distance from the neck line to the peak of the head (Picture 4). We should aim to close the trade at or near the measured levels. But at the same time, it is worth remembering that the price may not immediately pass such a distance but return to the neck level for testing. Hence, patience is advised when trading this pattern.
In conclusion, I’d like to note that the ideal Head and shoulders pattern appears on the chart rarely. More often it’s possible to find a model with asymmetrical shoulders (as seen in Picture 3), for example. This should not confuse traders as long as the neck line was close to being horizontal at the same time and the head formed the largest peak among three other ones.