Prices displays patterns signaling a reverse is underway. These are called trend reversal chart patterns, and one of the most well known is the head and shoulders chart pattern. It indicates an uptrend is likely over and a downtrend is now underway. A head and shoulders reversal pattern also occurs at market bottoms, following a downtrend, and is called an inverse head and shoulders chart pattern.
Head and shoulders chart patterns occur in all markets, and on all time frames. Here’s what it looks like, how it is interpreted and ultimately how it can be traded.
How to Trade the Head and Shoulders Chart Pattern
The head and shoulders pattern is a reversal pattern because it shows an uptrend is likely over. The pattern is created by the price rallying into a first high (left shoulder), then pulling back (left armpit), rallying to a new high (head), pulling back (right armpit), rallying to a lower high than the head (right shoulder) and the proceeding to drop again. Here’s what it looks like on a chart.
Figure 1. Head and Shoulders Chart Pattern on NZD/USD 30 Minute Chart
A Neckline connects the left armpit low to the right armpit low, forming a neckline. After the right shoulder has formed, if the price drops below the neckline the pattern is considered complete, and a reversal is underway. Occasionally the neckline won’t be of use, because it is angled too steeply (either up or down) to provide a viable entry. When this occur, use the right armpit low as an alternative. If the price drops below the neckline, or the right armpit low, consider the pattern complete.
A completed pattern presents a trading opportunity. Take a short trade when the head and shoulders chart pattern completes (price breaks below right armpit low or neckline). Place a stop loss order above the right shoulder. Calculate a target for the trade by measuring the height of the pattern, and subtracting it from the breakout price. In figure 1, take the difference between 0.8395, which is the head, and the low of the pattern at 0.8370, which is the low of the armpits, to get a height of 25 pips. Subtract this height from 0.8370, the breakout price, to get a target of 0.8345.
Understanding trends shows why the pattern works. An uptrend is defined as higher swing highs and higher swing lows. A downtrend is lower swing highs and lower swing lows. Therefore, by the time the right shoulder peaks, and starts to drop again, experienced traders will already be assuming a downtrend is in place. Waiting for the breakout of the neckline results in traders getting into the downtrend later than they need to.
This doesn’t mean the head and shoulders is a bad pattern; the pattern is just showing a transition from an uptrend to a downtrend. Work on honing your trending following skills so you don’t need to wait for the breakout, but can rather look for a short immediately after the lower high forms on the right shoulder and price begins to drop again. This gives a more favorable entry point, a tighter stop (still above right shoulder) and more room to profit if the price reaches the target.
Either way of trading the pattern could result in a loss if the price doesn’t drop as anticipated, with the latter method though, you lose less. The downside of the latter method is that you may get pre-maturely stopped out if the price doesn’t proceed lower right away. Pick a method and test your implementation in a demo account to see which works better for you.
How to Trade the Inverse Head and Shoulders Chart Pattern
An inverse head and shoulders has the same structure as discussed above, except it is flipped upside down.
Figure 2. Inverse Head and Shoulders Chart Pattern on GBP/JPY Daily Chart
The inverse pattern is traded in the same way. The traditional method is to buy when the price breaks above the neckline of the inverse pattern (or the right armpit high if the neckline is too angled to be relevant). Place a stop loss order below the right shoulder. Find the difference between the high and low of the pattern, and then add that distance to the breakout price to attain a target price for the trade.
Another option is to go long once the right shoulder makes a higher low than the head, and then starts moving higher again. This will result in a slightly earlier entry than the neckline method. Use the same stop loss location and target estimate.
The Final Word on Trading the Head and Shoulders
The head and shoulders chart pattern is one of the most popular chart patterns around. It’s easy to spot, but really only shows a transition from an uptrend to downtrend. Understanding the transition–the higher highs on the left side of the pattern to lower highs on the right side of the pattern–is the key take away here. Trade the head and shoulders in the traditional way, waiting for a break below the neckline, or trade it using the more aggressive approach. The more aggressive approach requires a bit more experience at reading trends, and requires an entry once the price forms the right shoulder and then begins to drop again. Practice spotting these patterns and then test out which entry method works better for you in a demo account.
Inverse head and shoulders are traded in a similar way, except occur after a market decline, and indicate the trend is turning higher. All chart patterns are fallible and losing trades will occur, this is why a stop loss is used on all positions.
For more on trading chart patterns and other forex trading strategies, check out the Forex Trading Strategies Guide for Day and Swing Traders eBook, by Cory Mitchell.
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