What is the Head and Shoulders Chart Pattern?
The head and shoulders chart pattern is a classic technical analysis pattern that signals a potential trend reversal in the market. It gets its name from its resemblance to a human head and shoulders when viewed on a price chart. The head and shoulders is a bearish reversal pattern that forms after an uptrend and indicates that a downtrend may be on the horizon.
The head and shoulders pattern is widely used by traders and investors to identify opportunities to go short or exit long positions before a possible bearish trend reversal. It is one of the most reliable and well-known chart patterns in technical analysis. Let's take an in-depth look at how to recognize and trade this high-probability pattern.
Anatomy of the Head and Shoulders Pattern
The head and shoulders pattern consists of four main components:
Left shoulder - Forms after an uptrend as the price makes a higher high and then pulls back
Head - The price makes an even higher high and then declines again, forming a peak
Right shoulder - The price rallies again but fails to exceed the high of the head before declining once more
Neckline - The support level connecting the lows of the left shoulder, head, and right shoulder
After the right shoulder forms and the price breaks below the neckline support, the head and shoulders pattern is considered complete and a bearish trend reversal may be underway. The pattern can take weeks or months to fully develop on a daily chart.
Key Characteristics of a Head and Shoulders Top
Occurs after an established uptrend and signals a bearish reversal
Has three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being lower and roughly equal
The bottoms of the left shoulder, head, and right shoulder form the neckline support level
The pattern is confirmed when the price decisively breaks below the neckline after the right shoulder
Volume often declines on each successive advance from left shoulder to head to right shoulder
How to Trade the Head and Shoulders Pattern
Once a head and shoulders top is identified and confirmed, traders look to open short positions or exit longs to profit from the expected decline. Here are the key steps to trading this pattern:
Identify the head and shoulders pattern on the chart with the left shoulder, head, right shoulder, and neckline clearly visible
Wait for the price to decisively close below the neckline support level after the right shoulder to confirm the pattern
Enter a short position or exit longs on a break and close below the neckline
Place a stop loss order just above the right shoulder or neckline to control risk
Set a profit target based on the height of the pattern subtracted from the neckline breakout point (more on this below)
Exit a portion of the position at the target level and trail a stop on the rest to capture any further downside
Profit Target Projection
One of the most useful aspects of the head and shoulders pattern is that it provides a measured move price objective. The expected decline after the neckline break is approximately equal to the vertical distance from the top of the head to the neckline.
In other words, take the height of the pattern and subtract it from the neckline to arrive at the minimum downside target. For example, if the head peaked at $100, the neckline is at $80, and the price breaks the neckline at $75, the projected measured move target would be:
$100 (head) - $80 (neckline) = $20 (pattern height)
$75 (breakdown point) - $20 (pattern height) = $55 (price target)
The price target serves as a guide for setting profit objectives and determining reward-to-risk ratios. Traders can look to take profits at or slightly above this level. The target is a minimum, as sometimes the breakdown from a head and shoulders top can extend much further.
Variations of the Head and Shoulders Pattern
The head and shoulders pattern has a couple common variations that traders should be aware of:
Inverse Head and Shoulders
The inverse head and shoulders, as the name implies, is simply the head and shoulders pattern flipped upside down. Instead of a bearish reversal, it signals a potential bullish reversal at the end of a downtrend.
The inverse head and shoulders has the same structure - left shoulder, head, right shoulder, neckline - only inverted. The shoulders form lows instead of highs, and the head is a lower low instead of a higher high. A break above the neckline triggers a long entry signal with a price target equal to the height of the pattern added to the breakout point.
Head and Shoulders Continuation
Sometimes what appears to be a head and shoulders reversal pattern can end up being a continuation pattern instead. If the price breaks the neckline but then quickly reverses and starts trending in the original direction again, it's known as a head and shoulders continuation.
This scenario illustrates why it's important to wait for confirmation of the pattern with a decisive break of the neckline before acting on it. A head and shoulders continuation can trap traders looking to fade the pattern and result in sharp losses if the original trend resumes.
Tips for Trading Head and Shoulders Patterns
Here are some tips to help you identify and trade head and shoulders patterns more effectively:
The pattern should stand out visually and be relatively obvious - if you have to strain to see it, it's probably not there
The left and right shoulders should form distinct peaks that are lower than the head
Look for a volume pattern of higher volume on the left shoulder, lower volume on the head, and lower still on the right shoulder
Wait for the neckline to be decisively broken before entering a trade - don't try to anticipate the breakdown
Use the measured move target as a guide but watch price action closely and trail stops to maximize gains
Combine other technical analysis tools and indicators with the pattern for confirmation, such as moving averages, momentum oscillators, and support/resistance levels
Limitations of the Head and Shoulders Pattern
While the head and shoulders is one of the most popular and reliable classical chart patterns, it's not infallible. No single pattern works 100% of the time. Here are some key limitations to be aware of:
The pattern can take a long time to develop, sometimes several months, during which time the price can move against you
Head and shoulders patterns don't always lead to trend reversals - sometimes the breakdown is a fake-out and the price continues in the original direction
The profit target is just an estimate based on the size of the pattern - it's not set in stone and the actual decline may be more or less
Like all technical patterns, the head and shoulders should be used in conjunction with other forms of analysis, not in isolation
Despite these limitations, the head and shoulders remains one of the most widely used and effective tools for spotting potential trend reversals in any market. By learning to identify the pattern, measure the profit target, and manage the trade properly, you can use it to capitalize on bearish trend changes across all time frames.
Conclusion
The head and shoulders chart pattern is a powerful and popular tool for traders and investors to identify potential trend reversals. This bearish signal forms at the end of an uptrend and consists of three peaks - two shoulders and a higher head - with a neckline support level. A decisive break below the neckline confirms the pattern and projects a decline equal to the height of the formation.
To trade the head and shoulders, wait for the neckline to be broken and then enter a short position or exit longs. Place a stop above the right shoulder and set a profit target based on the measured move. Trail stops to maximize gains. Also watch for inverse head and shoulders patterns signaling bullish reversals and head and shoulders continuations that can fake out traders.
While the head and shoulders is a reliable pattern, it's not perfect. It can take time to form, the breakdown isn't always valid, and price can exceed or fall short of the target. Use the head and shoulders in combination with other technical analysis for best results.
By understanding how to spot and trade the head and shoulders chart pattern, you can identify high-probability bearish reversal points in any market. Incorporate this valuable tool into your trading strategy to capture profitable opportunities when trends change direction.