How to trade a head and shoulders pattern

Trading a head and shoulders pattern requires the consideration of a whole range of factors, including the placement of stops, entry levels and targets.

Chart
Source: Bloomberg

Technical analysts use a whole host of methods to find turning points in charts, be it through the use of indicators, patterns, or historical highs and lows.

However, while indicators are very popular, the use of patterns hold additional value given the direct relationship with the price. Such patterns will give you an idea of where the price could go next, while also providing crucial elements such as where to place your stop loss and targets.

What is the head and shoulders pattern?

One of the most popular patterns is the head and shoulders, which is commonly used to find market reversals. For a traditional head and shoulders formation, the pattern is created through the failure to create a new higher high, followed by the break below the prior swing low. The opposite is true for an inverse head and shoulders.

This usage of swing highs and swing lows to determine market direction also allows for the easy understanding of more complex head and shoulders formations.

Spotting the head and shoulders reversal pattern

For now, sticking with the traditional head and shoulders formation, the example below highlights its traditional form as a market top reversal pattern. This shift from the creation of higher highs and lows, to a scenario which ultimately resolves with lower highs and lows completes the reversal signal.

Utilising this shift in the sequence of highs and lows, traders will see a head and shoulders formation as a reversal pattern around which they can trade.

Trading a head and shoulders pattern

Trading a head and shoulders pattern can involve substantial idiosyncrasies. Looking for short positions on the initial break of the neckline can be fraught with danger, given the importance and repercussions of breaking that support level.

This can raise the chance of a ‘fake-out’, where the price breaks the neckline and then reverses higher once more. With that in mind, it makes sense to seek some form of confirmation that the break will last.

One such method is to await a closed candle below the neckline. The higher the timeframe of the candle, the greater amount of confirmation a close below support would provide.

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. This allows for greater confirmation that price action can sustain below that neckline. However, it also increases the likeliness that a trader will miss the entry, with a rapid breakdown often meaning no such retest occurs.

Using targets and stops

Each situation is different in trading, yet as a rule of thumb, a head and shoulders breakdown would mean you will want to look at the prior swing high for stop losses.

Acknowledging the fact that a head and shoulders pattern is borne from a reversal of higher highs and lows, into lower highs and lows, it makes sense that to negate the new bearish outlook, you would need to see a break above the right shoulder.

Targets are typically a projection of the height of the pattern, with a low risk target equivalent to the distance between the neckline and right shoulder (1/1 risk-to-reward). Meanwhile, the eventual target is derived by projecting the neckline to head height from the eventual breakout point.

This would thus highlight that the risk-to-reward of the trade would be a function of the ratio in size between the right shoulder and head. On this occasion, we would be looking at a loss of around 500 points, with a profit of 800. This provides a 1.625 risk-to-reward ratio.

Conclusion

Perhaps this would not be perfect for some, but it is worthwhile noting that these formations can differ significantly. Not all head and shoulders formations are made equal, and while trading them it should be noted that their profitability can rely on that ratio between the shoulder and head size. 

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