How to correctly trade the Head and Shoulders pattern is the topic that we’ll like to expand upon and give traders further insights into one of the most powerful reversal patterns. Now, our team at Learn to Trade for Profit has been around the markets for a long time to understand that traders have the tendencies to over-complicate things. Our goal is pretty easy to guess: we want to bring simplicity back into the “game” of trading.
The Head and Shoulders pattern is a universal pattern that can appear on any market and is suitable for all types of trading styles because the pattern can be shown up on any time frame. This head and shoulders strategy is similar to “The Engulfing Candle Price Action Pattern” that we write about recently.
These are all pure price action strategies that don’t require the use of any indicators, however, if you like to mix things together check out the best moving average strategy ever created “The Moving Average Bounce Strategy.”
Now, let’s turn our focus back to how to correctly trade the Head and Shoulders pattern.
As we already mentioned, no indicators are required to trade the Head and Shoulders pattern.
What is the Head and Shoulders Pattern?
In technical analysis, the Head and Shoulders pattern is a reversal pattern that can be found either at the end of a bullish trend or at the end of a bearish trend, in which case it’s called an inverse Head and Shoulders pattern.
I know, this pattern has a funny name but don’t be misguided because it’s a pattern that has been used for a very long time.
Like all reversal patterns, this pattern is a failure of markets to move in a particular direction. The constant failed attempts of an instrument to move in the direction of the prevailing trend lead the market to reverse.
Defining the Head and Shoulders Pattern
Let’s not waste any more time and get straight into defining the Head and Shoulders pattern. We can break down the Head and shoulders pattern into five pieces:
- You have to have a strong bullish trend prior to identifying the Head and Shoulders pattern
- The price develops a swing high point and has the first retracement – this swing high point is called the Left Shoulder.
- After the retracement the price makes a new swing high point higher than the initial swing high and subsequently declines again – this swing high point is called the Head.
- The price rises for the third time, but only to the level of the first swing high point, before declining again – this swing high point is called the Right Shoulder.
- The reaction lows of each peak can be connected to form support – this is called the Neckline.
Figure 1: Head and Shoulders Pattern
Basically, the Head and Shoulders pattern includes three consecutive peaks with the middle peak (the Head) being the highest and the two other peaks (shoulders) being low and approximately equal.
You can simply turn upside down the above figure and you get an inverse Head and Shoulders pattern that normally appears at the end of a bearish trend and at the beginning of a new bullish trend.
Important note: While the above figure represents the ideal Head and Shoulders pattern in the real market often times you’ll see the Head and Shoulders pattern has slight variations (see Figure 2) which is the reason why you need to be very flexible in interpreting the Head and Shoulders pattern rules.
Figure 2: AUD/USD 1H Head and Shoulders
How to trade Head and Shoulders pattern successfully? This is probably the most important question that any trader should have.
The Head and Shoulders Strategy Rules
In this section of the article, we’re going to discuss about the Head and Shoulders strategy. You’ll learn when to entry a buy or a sell, but also where to place your stop loss and last but not least where to take profits.
Head and Shoulders Entry Strategy
The Head and Shoulders entry strategy offers you two entry techniques:
- Entry when the right shoulder is developing. Normally, we prefer to see symmetry with the left shoulder so we enter short once the left shoulder high price is hit. Sometimes the right shoulder will fall short of touching the left shoulder high price. But, don’t worry, the second entry technique can guarantee you a trade.
Figure 3: EUR/USD 15-Minute TF
- The second head and shoulders entry technique is to wait for the neckline breakout.
Before to look for the neckline breakout we need to learn how to draw the neckline, right?
Here, you go:
Figure 4: How to Draw the Neckline
The neckline can be formed by connecting together the end of the LEFT shoulder and the end of the head (see Figure 4).
Now that you know how to draw the neckline, it’s time to switch your focus to the neckline breakout entry technique. This is quite simple, see figure below:
Figure 5: Head and Shoulders Neckline Breakout
We have learned how to enter the Head and Shoulders pattern, but now it’s time to learn how to protect your account balance and use a protective stop loss order.
Head and Shoulders Pattern Stop Loss
For the Head and Shoulders pattern, you normally want to place your protective stop loss above the HEAD. We don’t want to add any extra buffer to our SL because even a false breakout of just 1 pip above the Head will invalidate the Head and Shoulders pattern.
Figure 6: Head and Shoulders Pattern – Stop Loss Placement
Head and Shoulders Pattern Take Profit
The Head and Shoulders is an amazing pattern because it can measure the profit target with a high level of accuracy. You can project your take profit level by measuring the distance from the neckline to the top of the head and then project that measurement to the downside.
See chart below of an actual example, how to project your Head and Shoulders profit target.
Figure 7: Head and Shoulders – Project Profit Target
Note** The above was an example of a SELL trade using the Head and Shoulders pattern. Use the exact same rules for the Inverse Head and Shoulders Pattern for a BUY trade. In the figure below you can see an actual SELL trade example, using the Head and Shoulders pattern.
Take a look:
Figure 8: Inverse Head and Shoulders Pattern
The Head and Shoulders pattern only works in up-trends, while in a downtrend, we have the inverse Head and Shoulders pattern. We encourage you to stay away from complexity and move towards something that is simple to understand like the Head and Shoulders pattern. We don’t try to predict tops and bottoms because that’s a loser’s game. We elaborate more on why it’s bad for your account balance trying to predict tops and bottoms here: Secret of Wealthy Traders #4: Don’t pick tops and bottoms.
The Head and Shoulders pattern gives you the extra confirmation needed that a top is in place so you won’t be forced to try picking a top.
Thank you for reading!