A head and shoulders pattern is considered to be one of the most reliable trend reversal patterns which signals that an upward trend is nearing its end. In this article, we explore how the head and shoulders pattern forms, and what its appearance is telling traders.
Identifying Head and Shoulders pattern
A prospective head and shoulders pattern appears as a baseline (neckline) with three peaks where the middle peak is the highest (head), while the outside two are close in height (shoulders). This pattern typically occurs after a substantial rise in price or at the end of the established uptrend.
The neckline shows an overlap in prices of these three distinct peaks. The neckline is drawn by connecting the lowest points of the pattern. It can be horizontal or have an upward/downward tilt. The more times the prices overlap, the stronger the pattern could be. If a head and shoulder pattern is formed on higher time frames, has symmetry in shoulders, and has a head that is not higher than 2.5 times the shoulder range, it is believed to have a higher chance of success.
Volume is considered to play an important role during the head and shoulders pattern formation. The consensus is that the left shoulder should have the highest volume, the head should take place on lower volume, and the right shoulder should have the least volume. This is not a requirement for the head and shoulders formation, but rather a general observation and early warning of diminishing buying pressure.
When the third peak is formed and the price approaches the neckline, the volume should expand on the breaking point. If the volume is low during the breakout, it could hint at the further testing of the breakout level. In case of decreased volume during a pullback, the asset may experience a potential bounce from the neckline level. At the same time, a high-volume breakdown may not lead to a pullback, indicating significant bearish momentum.
In the chart above, the price formed an uptrending neckline with several overlaps. The volume was decreasing during the entire pattern formation, and expanded when the price reached a breakout point. The price moved downwards, forming a support level (the red dotted line).
However, the asset experienced a throwback to the neckline level (the yellow dotted line). The reason could be relatively low volume during a breakdown. But since the asset showed decreased volume during a pullback as well, the price managed to bounce from the neckline level and continued the downward movement.
Trading Head and Shoulders pattern
A common practice to identify the potential price target after pattern formation is adding the height of the head to the breakout point. However, many people have different opinions on measuring this range. Some traders use the difference between the highest point of the head and neckline to calculate the potential price target, while others measure the target using the lowest point of the highest candlestick.
In the example above, the price target (the yellow dotted line) is calculated using a more conservative way, with the lowest point of the highest candlestick. When trying to evaluate the price target, pay attention to potential support levels. For example, the price target in the chart above corresponds with a major support level.
As a general rule, traders can enter the market with a short position, only when the head and shoulders pattern is completed. Entry can be made once the neckline breaks to the downside (1) or when the price rebounds from the neckline level after the pullback (2).
However, if the breakdown is accompanied by high volume, generally, there can be no retest. Also, there can be no pullback if a breakout level is located at a major support level. In these cases, the common entry point could be only the breakout point.
Although a head and shoulders pattern is considered one of the most reliable chart formations, it can fail. In most cases, it happens when the volume showcases an anomaly, or the market structure is looking for consolidation rather than a retracement. That is why some traders may want to place stop losses as a protection against unexpected price movements.
Stop losses can be placed at the high of the candle, just before the breakout (the green dotted line) or even higher. This approach may differ depending on the average volatility of traded assets.
Inverse Head and Shoulders pattern
A head and shoulders pattern has a bullish version, called the inverse head and shoulders or head and shoulders bottom. It is the opposite of the head and shoulders pattern and has the same formation rules. The inverse head and shoulders pattern consists of three valleys, where the middle one is the deepest (head), while the outside two are close in height (shoulders). The pattern has a neckline that connects its peaks. The volume works similarly to the bearish head and shoulders, meaning it tends to decrease with consecutive valleys and extend during a breakout.
Keep in mind that the price target (the yellow dotted line) is an estimate and the price may continue moving in the breakout direction if there is enough momentum. In the case of low momentum, the price may start consolidating before reaching the anticipated price target.
The head and shoulders pattern is considered to be a powerful pattern to spot a potential trend reversal that may occur in any time frame. When trading this pattern, traders can wait for its confirmation and might consider not anticipating its formation in advance. Otherwise, this may lead to hasty decisions and false expectations. Traders should look closely at the volume during a neckline breakout to realize whether or not a pullback may follow. As additional confirmation of potential trend reversal, traders can also analyze momentum indicators while a head and shoulders pattern is forming.