A head and shoulders pattern gets its name from the way it looks on the charts. It looks like a head, with a shoulder on each side. If you can picture the human head and the shoulders that bestride the head, then you will be able to understand some fundamental elements of this pattern.
The head and shoulders pattern is a bearish reversal pattern which is basically formed by three successive price peaks in an uptrend. The second price peak which forms the “head” in the pattern, is usually higher than the preceding and succeeding price peaks which form the shoulders. Located in between each peak is a reaction low, formed by a dip in price. So we have three price peaks and two intervening reaction lows. Each of these reaction dips in price can be connected with a support line known as the neckline. The neckline is a very important landmark in this pattern, as it forms the basis of the trade setup with the head and shoulders pattern.
Criteria for a Valid Trade with the Head and Shoulders Pattern
Pattern identification is very important. That is why it is important for the trader to understand the pre-conditions that must be in for successful identification and trading with this pattern.
Here the pre-conditions for identifying a valid head and shoulders reversal pattern. Please note that there is a variation of the head and shoulders pattern which works as a continuation pattern. There are elements of that pattern which are distinct from the reversal pattern being described here. So you must ensure that these conditions are met for trading the head and shoulders reversal pattern.
- There has to be an existing uptrend. A bearish reversal can only occur at the top of a trend and nowhere else.
- Three successive peaks must form, with two reaction lows in between each peak. The 2nd peak MUST be higher than the 1st and 3rd.
- After the 3rd peak, price should dip downwards and close below the neckline by at least a 3% penetration. More on this later.
- The profit target projection is set to the distance between the neckline and the head.
- Larger patterns usually produce bigger reversal moves. Size here connotes the length and width of the pattern. You will see how this is applied for a head and shoulders pattern. Height measures pattern volatility; width measures time taken for pattern to fully evolve. Bar charts and candlestick charts mostly use the height of the pattern; point and figure charts use the pattern width.
- The buying volume drops off as each successive peak is attained, followed by an increase in selling volume when the neckline is broken successfully.
How Does the Pattern Evolve?
The complete head and shoulders pattern is a reversal pattern which will form an A-B-C-D-E-F-G pattern where:
- Point A is the left shoulder (1st peak).
- Point B is the 1st reaction dip.
- Point C is the head (2nd peak), which is located higher than the left shoulder.
- Point D is the 2nd reaction dip.
- Point E is the right shoulder (3rd peak).
- Point F is where the price touches the neckline. The price must close below F for the pattern to be complete.
- Point G is the entry point of the trade, where price makes a pullback to the broken neckline and is resisted at that point.
This chart outlines all that has been discussed about this pattern. The only info missing here is the volume information. First there is a prior uptrend, peaks at point A to form the first shoulder. Please note that sometimes, price action can be very rapid, which leads to very thin shoulder formations as seen on this chart.
A corrective dip to point B follows, after which a price surge above the 1st peak (point C) and another corrective dip (Point D) completes the head. A 3rd price peak and further correction to point F on the neckline completes the 3rd shoulder.
The neckline is drawn across points B and D and extended into the future. The extended neckline will serve as a future reference point if the price makes a pullback after breaking below the neckline.
Point F is the valley of decision. If the price candle/bar closes below this line, the reversal is confirmed. However, the price attempts a pullback to the broken neckline about 80% of the time (point G). A Sell Limit order can be set using the neckline as entry price.
The first profit target (TP1) is calculated by extrapolating the pattern height (Line 1) downwards from the neckline (Line 2). Please notice that the TP1 is also at a price level where a previous support has formed.
With prices now trending downwards, a price retracement to the upside can occur after you must have exited the trade. If this happens, your neckline will function as a resistance, providing a reference point for a secondary short order (point H). If the retracement does not close above the neckline at point H, simply sell again to bank more profits.
Important Points to Note On Trade Entry
In order not to mess up the trade entry, two important points must be noted.
- You must watch the volume pattern. Typically buying volume reduces with each successive peak. Then the breakout to the downside is accompanied by an increase in selling volume.
- The price bar must close below the neckline with a 3% penetration. The 3% here refers to the number of pips that make up the move from the neckline to the 2nd price peak, multiplied by 0.3. So if the Line 1 distance is 100 pips, the closing penetration should be at least 0.3 X 100 pips (i.e. 30 pips).
So trade the pattern with confidence and make good use of it.
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