Head and Shoulders Pattern Trading Strategy Guide

What is the Head and Shoulders Pattern?

The head and shoulders pattern is a unique chart formation that usually appears during an uptrend. When it appears in the candlestick chart of a stock, the price generally takes a downward turn.

The price pattern gets its name from its distinctive shape, which resembles a human head with two shoulders. The head and shoulders stock chart pattern also has an inverse variant. This particular variant appears during a downtrend and often signals a bullish reversal.

The Head and Shoulders pattern is widely considered to be a reliable price action indicator that can predict trend reversals in technical analysis.

Features of the Head and Shoulders Pattern

To accurately identify and interpret a head and shoulders pattern, you must first understand its key components. The pattern has four features that you should pay attention to: the left shoulder, the head, the right shoulder, and the neckline. Here is a detailed overview of each of the pattern’s features.

• The Left Shoulder

  The left shoulder is the first peak that forms during an uptrend and represents a new high in the prevailing trend.

• The Head

  After the left shoulder forms, the price moves downward for a while before rising back up again. When the price rises the second time, it goes past the high of the left shoulder to create an even higher peak. This peak is the head of the pattern and represents the highest point in the current uptrend.

• The Right Shoulder

  Once the highest point in the current uptrend (the head) is formed, the price again falls before recovering. During the recovery, however, the price does not reach the height of the head. Instead, it only rises to near the level of the left shoulder. This forms the right shoulder of the pattern.

• The Neckline

  One of the most crucial components of the head and shoulders pattern in a stock is the neckline. It is essentially a line that connects the lowest points formed on both the left and right sides of the head. Depending on how the pattern has formed, the neckline can either be completely horizontal or slightly slanted upward or downward.

In addition to the features mentioned above, there are two other components of the head and shoulders chart pattern you must closely watch. Here is a quick overview of the other two components.

• Volume

Although the volume is not a visual component of the pattern, it is still very valuable in confirming the formation of the head and shoulders pattern. Typically, the volume is the highest during the formation of the left shoulder and head. It then slowly decreases during the formation of the right shoulder.

• Breakout

The head and shoulders chart pattern is said to be complete when the price of the asset breaks below the neckline after the formation of the right shoulder. Once the price breaks below the neckline, the volume of the asset rises sharply, confirming the validity of the pattern.

Now, it is important to remember that while these features are typical of a head and shoulders pattern, they may vary slightly in appearance depending on the market conditions. The key to identifying the pattern accurately is to understand the underlying principle behind the formation of the pattern, which is the failed attempt of the asset to make new highs, thereby signalling a potential trend reversal.

How to Trade the Head and Shoulders Pattern?

Trading the head and shoulders pattern effectively requires a systematic approach. Here's a step-by-step guide on how to trade this pattern.

• Entry Point

The most common point of entry, once the head and shoulders pattern in stock appears, is the breakout point. As you have already seen, the breakout point occurs when the price of the stock breaks the neckline after forming the right shoulder. Once you have identified the breakout point, there are three things you must keep in mind:

• Wait for Confirmation

It is not advisable to enter into a trade as soon as you see the head and shoulders on the charts. This is because the price of the asset may sometimes move in the unintended direction due to factors like high market volatility. Fortunately, you can avoid falling for false signals by simply waiting for a price action confirmation. Wait until the price of the asset goes below the neckline to enter into a position.

• Look for Volume Confirmation

For a breakout to be genuine and strong, it must be accompanied by a spike in trading volume, which indicates strong selling pressure and adds credibility. Therefore, once you obtain price action confirmation, look for increasing volumes before entering into a position.

• Enter During the Retest

Sometimes, the price of the asset may retest the neckline from below after breaking out. If you end up missing the initial entry point, such situations can offer a second chance to enter into the trade.

• Stop-Loss Point

For any trading strategy, proper risk management is key to protecting your position from losing value due to adverse market movements. The same logic applies to the head and shoulders pattern as well. By setting a stop-loss point, you can manage risk efficiently and prevent significant losses. Here are three different points at which you can set the stop-loss for this particular price pattern.

• Above the Right Shoulder

When trading the head and shoulders chart pattern, consider setting a stop-loss point at or just above the peak of the right shoulder. This is based on the logic that if the price rises beyond the peak of the right shoulder, the pattern is invalidated.

• Above the Head

If you are a more aggressive trader with a stronger ability to withstand market volatility and risk, you could consider setting the stop-loss point at or just above the peak of the head. Although this increases the potential loss if the trade goes against you, this point will give you more room for price fluctuations and is ideal for assets experiencing high levels of volatility.

• Fixed Stop Loss

Alternatively, if you are even more conservative in your trading approach, you could consider setting the stop-loss point based on a fixed percentage of the capital used for the trade or a specific price point.

• Take-Profit or Exit Point

Determining when to take profits is just as important as knowing where to enter the trade. This will prevent a profitable trade from going into losses due to not having a clear plan for an exit. Furthermore, having a predetermined profit target helps maintain a favourable risk-to-reward ratio. Here are some methods for setting take-profit levels:

• Measured Exit

This is one of the most common methods of setting exit points for the head and shoulders pattern. All you need to do is measure the distance between the head of the pattern and the neckline and project the distance down from the breakout point. This gives you a minimum price target.

• Previous Support Levels

Alternatively, you can look for significant support levels below the neckline and use them as potential target prices.

• Fibonacci Retracement Levels

Some traders combine Fibonacci Retracement Levels with the head and shoulders pattern to determine take-profit points. The Fibonacci Retracement Levels are drawn from the head to the neckline breakout point to identify potential support levels. These levels are where the prices might reverse and can be used as potential take-profit points.

• Trailing Stop

Instead of a fixed take-profit point like the ones above, you may also consider using a trailing stop that moves as the price moves in your favour. This allows you to potentially capture more profit if the downtrend continues strongly.

Now, it is important to remember that taking partial profits at different levels can lead to better returns compared to exiting the position at once. Doing so enables you to secure some gains while continuing to benefit from the downtrend if it continues.

Conclusion

The head and shoulders pattern is a powerful price action formation on the charts, offering valuable insights into potential trend reversals. The clear structure of the pattern makes it easier to identify for both new and experienced traders. Meanwhile, the well-defined entry, stop-loss, and exit rules also make trading the pattern a lot easier compared to other price patterns.

That being said, like all price action indicators, the head and shoulders pattern is not flawless. The pattern may sometimes produce false signals, trapping potential traders in losing trades. This is precisely why it is important to put in place proper risk management measures. Doing so can prevent your positions from losing value due to the trade going against you.

Furthermore, for the best results, consider interpreting and using the head and shoulders stock chart pattern in conjunction with other technical indicators and fundamental analysis.

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