Head and Shoulders Chart Pattern Explained

The Head and Shoulders pattern, along with its counterpart, the Inverse Head and Shoulders, are among the most reliable and widely recognized chart formations in technical analysis. These patterns signal potential trend reversals, providing traders with valuable insights for making informed decisions.

What is the Head and Shoulders and Inverse Head and Shoulders Pattern?

The Head and Shoulders Top is a bearish reversal pattern that typically forms at the end of an uptrend. It consists of three peaks:

• Left Shoulder: An initial peak in price, followed by a decline.
• Head: A subsequent rally that exceeds the left shoulder, forming a higher peak, followed by another decline.
• Right Shoulder: A third rally that is similar in height to the left shoulder (and lower than the head), followed by a decline.
• Neckline: A line connecting the low points of the troughs between the shoulders and the head. A break below this neckline is a key confirmation signal.

The Inverse Head and Shoulders (also known as Head and Shoulders Bottom) is a bullish reversal pattern that typically forms at the end of a downtrend. It is a mirror image of the top pattern:

• Left Shoulder: An initial low in price, followed by a rally.
• Head: A subsequent decline that falls below the left shoulder, forming a lower low, followed by another rally.
• Right Shoulder: A third decline that is similar in depth to the left shoulder (and higher than the head), followed by a rally.
• Neckline: A line connecting the high points of the rallies between the shoulders and the head. A break above this neckline is a key confirmation signal.

Both patterns indicate a potential shift in market sentiment and the exhaustion of the prior trend.

How to identify Head and Shoulders and Inverse Head and Shoulders Pattern?

Identifying these patterns requires careful observation of price action and volume (though volume is not explicitly requested to be detailed here, it's often a confirming factor).

Identifying a Head and Shoulders Top (Bearish Scenario):

1. Prior Uptrend: The pattern must form after a significant uptrend.
2. Left Shoulder Formation: Price makes a peak (left shoulder) and then retraces.
3. Head Formation: Price rallies to a new high (the head), surpassing the left shoulder, and then declines again, typically to a level near the previous trough.
4. Right Shoulder Formation: Price rallies again but fails to reach the height of the head, forming a peak (right shoulder) that is roughly symmetrical to the left shoulder. This rally often occurs on lower volume than the rally that formed the head.
5. Neckline: Draw a line connecting the two troughs formed after the left shoulder and the head. The neckline can be horizontal or sloped. A downward slope is often considered more bearish.

Identifying an Inverse Head and Shoulders Bottom (Bullish Scenario):

1. Prior Downtrend: The pattern must form after a significant downtrend.
2. Left Shoulder Formation: Price makes a low (left shoulder) and then rallies.
3. Head Formation: Price declines to a new low (the head), below the left shoulder, and then rallies again, typically to a level near the previous peak.
4. Right Shoulder Formation: Price declines again but holds above the low of the head, forming a low (right shoulder) that is roughly symmetrical to the left shoulder. This decline often occurs on lower volume.
5. Neckline: Draw a line connecting the two peaks formed after the left shoulder and the head. The neckline can be horizontal or sloped. An upward slope is often considered more bullish.

How to trade Head and Shoulders and Inverse Head and Shoulders Pattern?

Trading these patterns involves waiting for confirmation, typically a breakout of the neckline, and then setting appropriate entry, stop-loss, and profit target levels.

Trading a Head and Shoulders Top (Bearish Trade):

1. Confirmation: Wait for the price to break decisively below the neckline. This is the signal to consider a short (sell) position. Some traders look for a close below the neckline for stronger confirmation.
2. Entry: Enter a short position on the breakout below the neckline or on a subsequent pullback that retests the neckline as resistance.
3. Stop-Loss: Place a stop-loss order above the right shoulder or, more conservatively, above the head.
4. Profit Target: The minimum price objective is calculated by measuring the vertical distance from the top of the head to the neckline and then subtracting that distance from the breakout point of the neckline.

Trading an Inverse Head and Shoulders Bottom (Bullish Trade):

1. Confirmation: Wait for the price to break decisively above the neckline. This is the signal to consider a long (buy) position. Some traders look for a close above the neckline.
2. Entry: Enter a long position on the breakout above the neckline or on a subsequent pullback that retests the neckline as support.
3. Stop-Loss: Place a stop-loss order below the right shoulder or, more conservatively, below the head.
4. Profit Target: The minimum price objective is calculated by measuring the vertical distance from the bottom of the head to the neckline and then adding that distance to the breakout point of the neckline.

Pro Tip

Always consider the broader market context and use other technical indicators or analysis techniques to confirm signals from Head and Shoulders patterns. Volume can also provide valuable confirmation; typically, volume is higher on the left shoulder and head, and diminishes on the right shoulder and during the breakout.

FAQ

Can you trade the Head and Shoulders pattern by itself?

• No, it's best used with other indicators or patterns in your trading strategy for confirmation and to increase reliability.

Can you trade the Head and Shoulders pattern in any market?

• Yes, the Head and Shoulders pattern can be identified and traded in various financial markets, including stocks, forex, commodities, and cryptocurrencies.

Can you trade the Head and Shoulders pattern on any timeframe?

• Yes, this pattern can appear on any timeframe, from short-term intraday charts to long-term daily or weekly charts, adapting to different trading styles.