The head and shoulders pattern is one of the most reliable and widely recognized reversal patterns in technical analysis. When this pattern forms after an uptrend, it signals that bullish momentum is weakening and a bearish reversal may be imminent. Understanding how to identify and trade this pattern can significantly improve your trading results.
What is the Head and Shoulders Pattern?
The head and shoulders pattern consists of three peaks: a higher middle peak (the head) flanked by two lower peaks (the shoulders) at roughly the same height. The pattern gets its name from its resemblance to a human head with shoulders on each side.
Pattern Components
- Left Shoulder: The first peak forms during an uptrend, followed by a pullback.
- Head: Price rallies above the left shoulder to form a higher peak, then pulls back again.
- Right Shoulder: Price rises again but fails to reach the height of the head, forming a lower peak.
- Neckline: A support line connecting the lows after the left shoulder and the head.
Key Insight: The neckline is crucial for confirming the pattern. A break below the neckline with strong volume confirms the reversal.
How to Identify the Pattern
Recognizing a valid head and shoulders pattern requires attention to several key characteristics.
Prerequisites for a Valid Pattern
- Prior Uptrend: The pattern must form after a significant uptrend to be a valid reversal signal.
- Symmetry: The shoulders should be roughly symmetrical in height and width, though perfect symmetry is rare.
- Volume Profile: Volume typically decreases from left shoulder to head to right shoulder.
- Neckline Angle: The neckline can be horizontal, upward sloping, or downward sloping.
Identifying a Head and Shoulders on AAPL
Imagine Apple stock rises from $150 to $175 (left shoulder), pulls back to $165, rallies to $185 (head), drops to $167, rises to $177 (right shoulder), then breaks below $165. This confirms the head and shoulders pattern.
Trading the Head and Shoulders Pattern
There are several approaches to trading this pattern, each with different risk-reward profiles.
Entry Strategies
- Neckline Break: Enter short when price breaks below the neckline on strong volume. This is the most conservative approach.
- Retest Entry: Wait for price to break the neckline, then retest it from below. This offers better risk-reward but may not always occur.
- Right Shoulder Formation: Aggressive traders may short during right shoulder formation, anticipating the breakdown.
Setting Your Price Target
The traditional price target is calculated by measuring the distance from the head to the neckline, then projecting that distance down from the neckline break point.
Calculating the Price Target
- Head peak: $185
- Neckline at breakpoint: $165
- Distance: $185 - $165 = $20
- Price target: $165 - $20 = $145
Stop Loss Placement
Proper stop loss placement is essential for managing risk.
- Above the Right Shoulder: Place your stop above the right shoulder peak for a conservative approach.
- Above the Neckline: A tighter stop just above the neckline offers better risk-reward but higher chance of being stopped out.
- Percentage-Based: Some traders use a fixed percentage above their entry point.
Inverse Head and Shoulders
The inverse head and shoulders is the bullish counterpart that signals a potential reversal from a downtrend to an uptrend.
Pattern Characteristics
- Forms at the end of a downtrend
- Three troughs with the middle trough (head) being the lowest
- Breakout occurs above the neckline
- Signals bullish reversal
Trading Tip: Inverse head and shoulders patterns are traded the same way as regular patterns, but in reverse. Enter long on a neckline break and set targets using the same measurement technique.
Volume Confirmation
Volume plays a crucial role in validating the head and shoulders pattern.
Ideal Volume Pattern
- Left Shoulder: High volume during the rally, moderate volume on the pullback.
- Head: Volume during the rally is often less than the left shoulder. This is an early warning sign.
- Right Shoulder: Even lower volume during the rally, showing weakening buying pressure.
- Breakdown: Volume should spike significantly when price breaks the neckline.
Common Mistakes to Avoid
Even experienced traders make errors when trading head and shoulders patterns.
- Trading Before Confirmation: Entering before the neckline breaks can lead to premature trades if the pattern fails.
- Ignoring Volume: A neckline break without volume increase is suspicious and may be a false signal.
- Poor Risk Management: Setting stops too tight or too loose can hurt your results.
- Forcing the Pattern: Not every three-peak formation is a head and shoulders. Be objective in your analysis.
- Ignoring the Larger Trend: A head and shoulders in a strong bull market may fail more often.
Pattern Variations
Not all head and shoulders patterns look the same. Understanding variations helps you identify more opportunities.
Complex Head and Shoulders
Sometimes the pattern forms with multiple heads or shoulders. As long as the overall structure remains intact, it can still be valid.
Sloping Necklines
- Downward Sloping: Considered more bearish, often leads to stronger breakdowns.
- Upward Sloping: Less bearish, may indicate the trend is fighting to continue higher.
- Horizontal: The classic formation, provides clear support levels.
Timeframe Considerations
Head and shoulders patterns can form on any timeframe, but their reliability varies.
- Daily and Weekly Charts: Most reliable, suitable for swing and position trading.
- Hourly Charts: Good for day trading, but require faster execution.
- 5-Minute Charts: Can be noisy, use with caution and additional confirmation.
Track Your Pattern Trades
Pro Trader Dashboard helps you track which chart patterns lead to your best trades. Analyze your head and shoulders setups and improve your pattern recognition.
Summary
The head and shoulders pattern is a powerful reversal signal that every trader should understand. Focus on proper identification, wait for neckline confirmation with volume, set realistic price targets, and always manage your risk. Remember that no pattern works 100% of the time, so always use proper position sizing and stop losses. With practice, you will become proficient at spotting and trading this classic chart pattern.
Related reading: Support and Resistance Levels and Double Top Pattern.