Head and shoulders chart pattern for traders

In this lesson, we dive into the head and shoulders chart pattern: a powerful tool widely recognised for its ability to signal potential trend reversals in financial markets. It typically indicates a shift from a bullish trend to a bearish trend.

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What is the head and shoulders pattern?

Chart patterns give traders an idea of where the price could go next, while also providing crucial guidance on where to place your stop-loss and targets.

One of the most popular patterns is the head and shoulders, commonly used to find market reversals. It's called head and shoulders because of its visual shape, resembling a head flanked by two shoulders.

In a market experiencing an uptrend, the price is making higher highs and higher lows. In a market that's in a downtrend, you’ll see lower price highs and lower price lows. What the head and shoulders pattern shows is the transition from uptrend to downtrend. That’s why we call it a reversal pattern.

We label the pattern as left shoulder, head, and right shoulder, and then we draw a support level where the major lows meet, which we refer to as the neckline.

If we look at the highs from the head to the right shoulder in the image below, it shows us the first point where the market is making lower highs after being in an uptrend. When the price breaks below the neckline, it confirms the pattern.

Now we have lower lows in conjunction with lower highs – the building blocks of a downtrend. This confirms the market has transitioned from an uptrend to a downtrend. The theory of proportion suggests that we can measure the height of the head to the neckline and project that distance from the breakout level to give ourselves a downside target from the pattern.

Traders use the head and shoulders pattern as a signal for trend changes. Those holding long positions may look to exit, while traders expecting further downside might consider short positions to profit from the anticipated decline.

Variations of the head and shoulders pattern

While the classic head and shoulders pattern is the most well-known, there are variations:

1. Inverse head and shoulders: this pattern is the opposite of the standard formation, signalling a potential bullish reversal in a downtrend (more on this in the next lesson).
2. Complex head and shoulders: this variation includes multiple shoulder peaks on each side of the head, making it more intricate but still following the same principle.

Using the head and shoulders pattern

Confirm the pattern

The head and shoulders pattern is confirmed when the price breaks below the neckline, signalling a potential downtrend. Remember: the shoulders may not be perfectly symmetrical, and the pattern requires a strong preceding uptrend to be valid.

Key components of the head and shoulders pattern:

1. Left shoulder: the initial peak representing the first phase of the uptrend
2. Head: the highest peak, surpassing the heights of both shoulders
3. Right shoulder: the third and final peak, similar in height to the left shoulder but lower than the head
4. Neckline: a support line drawn by connecting the lowest points between the shoulders and the head.

Formation stages of the head and shoulders pattern:

To effectively identify and trade the head and shoulders pattern, it's crucial to understand its formation stages:

1. Uptrend initiation: the market trends upward, creating the left shoulder
2. Pullback to neckline: a temporary decline brings the price back to the neckline
3. Head formation: the price rallies again, reaching a new high to form the head
4. Second pullback: another decline brings the price down to the neckline
5. Right shoulder formation: a final rise creates the right shoulder, lower than the head
6. Final decline: the price drops back down, testing the neckline once more.

Tip: In a textbook head and shoulders pattern, volume is typically highest during the formation of the left shoulder, decreases as the head forms, and is lowest during the right shoulder. Additionally, volume often picks up during the price declines from the left shoulder to the first trough and from the head to the second trough.

Set price targets

Once the pattern is confirmed, traders often set price targets to gauge potential profit opportunities. A common method is to measure the vertical distance from the head to the neckline and project this distance downward from the breakout point. This projection provides an estimate of how far the price might fall after the pattern completes.

Consider your trading strategy

When trading the head and shoulders pattern, traders might consider the following strategies:

1. Short entry: entering a short position when the price breaks below the neckline with increased volume
2. Stop-loss placement: setting a stop-loss order above the right shoulder or the head to manage risk
3. Target setting: using the measured move technique described earlier to set profit targets
4. Partial profit-taking: consider taking partial profits at predetermined levels to lock in gains

Understand time frames

The head and shoulders pattern can manifest across various timeframes, from intraday charts to monthly charts. Generally, patterns forming on longer timeframes are considered more reliable and significant. However, traders should choose a timeframe that aligns with their trading style and objectives.

Understand limitations and combine with other technical indicators

While the head and shoulders pattern is a powerful tool, it's not without limitations:

1. Subjectivity: pattern identification can be subjective and may vary among traders
2. False breakouts: the price may briefly break below the neckline before reversing, leading to false signals
3. Reliability: like all technical patterns, the head and shoulders is not 100% reliable

To enhance the reliability of your analysis, consider combining the head and shoulders pattern with other technical indicators:

1. Moving averages: use moving averages to confirm the overall trend direction
2. Relative Strength Index (RSI): look for overbought conditions near the head formation or on pullbacks from the breakout
3. Moving Average Convergence Divergence (MACD): check for bearish divergence during pattern formation

In the next lesson, we turn this all upside down and look at the inverse head and shoulders pattern.