Head and Shoulders Trading Strategy
The popular Head And Shoulders pattern
In this article, I will cover all you need to know about trading the Head and Shoulders pattern:
- Why do the Head and Shoulders patterns form?
- The rules of the Head and Shoulders pattern.
- How to measure the take profit level.
- Where to put your stop loss.
- Different entry strategies.
- When not to trade it.
The Head and Shoulders pattern is by far one of the most popular chart patterns, if not the most popular. Perhaps because of its reliability and easy identification. Another possible reason for the Head and Shoulders pattern popularity is that as new traders we tend to trade reversal patterns, and the Head and Shoulders is a great reversal pattern. I remember how excited I was the first time I learned how to spot the Head and Shoulders pattern and how to trade it.
What does the Head And Shoulders pattern look like?
In the chart below we have a pretty nice example of the Head and Shoulders pattern. There are three clear peaks, with a center bump that is higher than the rest. The left shoulder usually forms after a period of a bullish trend. Thereafter the prices make another push higher, printing the head peak. The entire pattern takes shape and is clear to us on the chart after the formation of the right shoulder, which is a lower higher after the head bump.
A trend line drawn along the bottoms of the two troughs between the three peaks forms the neckline. The line may slope in any direction but slopes upward about 52% of the time and downward 45% of the time with the remainder being horizontal. Usually, the left should have a higher trading volume and the right shoulder the lowest. Like any other chart pattern, the Head and Shoulders pattern is also not easy to see before the fact and is not confirmed until we have a break below the neckline.
Why does the Head and Shoulders pattern form?
Let’s assume for a while that you are a big bank, Institut or what use to be described as “Smart Money“. You are looking for a stock or any other asset you trade, in this example USDCHF. After doing your research, reviewing the fundamentals, you decide that buying USDCHF at 0,90500 (A) is a good value area. You start buying in mid-May. Now, your buying turns the situation and prices start to rise.
Soon you acquired all the contracts you wanted to buy, you sit down and wait. Other investors start to see, consider joining the bullish move and start buying as well. Prices surge further and in mid-July reaches 0,98700 at (B), you decide it is time to sell. After all, you have made a 9% profit. Your selling causes the rally to pause to then begin to retrace back down.
Seeing the bullish weakness you stop selling. Swing traders and daytraders buy the dip assuming a continuation of the bullish move, not aware of your selling. The decline halts and the asset rises again. As it rises additional traders join the bullish move. As prices reach 0,99700 at (C) you start selling again, that selling pressure force prices to start another retrace down. Yet again, the late buyers who missed the bullish move which made a higher high and printed the head of the pattern start buying the dip. Those late buyers do not have enough liquidity to make a new high, so after a short surge, the price fails to make a new high and print the right shoulder.
Technical traders and investors see the Head and Shoulders for what it is: a reversal pattern. They take their profit quietly and start selling in high hope of the prices to break the neckline and decline furthermore. Prices move lower break the neckline at (D), more and more traders see the break of support, volume rise on both the new selling pressure and bulls stops get triggered, that’s where we see prices move in a strong momentum to the downside.
Shape: After a bullish move, the pattern appears as three peaks, the center one is the highest.
Symmetry: The two shoulders should be at about the same price level. The distance from the shoulders to the head is usually the same (But not a must). You’ll find many different variations of the formation but a good looking symmetry is a very good clue.
Neckline: A trend line that connects the two lows of the shoulders forms the neckline. The line can slop up or down. Often used as a trigger signal to sell once broken.
Breakout and retest: Once the neckline is broken, prices may pull back and retest it to then continue moving down.
Different variations of the Head and Shoulders pattern.
Consider the chart below. We see a Head and Shoulders pattern, but with two left shoulders and two right shoulders. It is called a complex Head and Shoulders pattern. After all, it’s a Head and Shoulders pattern, too. In this example, we see also the typical retest of the broken neckline before the market keeps moving down. Like any other pattern, you can’t just wait for the perfect ones to trade, the market is never perfect and you can’t wait for those textbooks patterns alone (they are very rare).
Trend continuation Head and Shoulders
Most traders trade the Head and Shoulders pattern only as a counter-trend reversal pattern, while I found it very powerful as a trend continuation pattern. In the chart below I am showing you one of my favorite scenarios. The reversal started at the top in mid-February, with a nice and strong bearish momentum. In mid-March, prices found support and started a correction. Here we see a complex correction that formed what I call a trend continuation Head and Shoulders pattern. In such a scenario, you’ll be trading in the direction of the ongoing strong bearish momentum which will give a higher probability trade.
Head and Shoulders failure
No way, is that possible? Head and Shoulders is the holy grail! Well sorry buddy, no chart pattern is. Now, even though the Head and Shoulders pattern rarely fails, it still happens from time to time.
How to avoid failure?
What is important, is that you never trade any pattern in the middle of nowhere. Always trade the pattern at a pre-planned level of interest, a strong level of resistance, or high probability reversal areas. Trade in the direction of the major trend.
So, you’ve done your research, reviewed the fundamentals and want to short a market. The levels are marked on your chart, the plan is ready and you’re waiting for bearish evidence to happen at your pre-planned level. The market reaches your level and prints a Head and Shoulders pattern. What next?
Well, we want to know how big is our profit target and our stop loss level. Compute the formation height by subtracting the value of the neckline from the highest high reached in the head, measured vertically. Subtract the result from the breakout price where prices pierce the neckline, or, if the neckline slopes downward, close below the right shoulder low. The result is the minimum target price to which prices descend.
So far so good, we have our target. Now, let’s see how to place our stop-loss. There are at least two schools on how to place a stop-loss when trading the Head and Shoulders pattern. The first one, you put the stop above the head peak (Bigger stop). The second one, and that is how I mostly trade the Head and Shoulders, you place the stop-loss above the right shoulder. If the right shoulder is higher than the left shoulder, and the market breaks above the right shoulder that is, in my opinion, a strong signal that the bulls are not done yet.
What about the entry?
For the entry, there are also many ways. Some traders like to enter after a candle closes below the neckline, while other traders play it as sell stop below the neckline, as soon as the market reaches that order, it triggers and they are in the sell. Another way to play it is to wait for a strong break and retest to enter using a sell limit at the neckline, or after the market showing bearish evidence and starting a decline. I do not trade sell stop below the neckline, I wait for at least a 1H-4H candle close below the neckline. If the close happens to be very wide and far away from the neckline, I wait for the retest and sell it using Sell Limit Order placed at the neckline. Below you’ll see some different examples of entries to choose from, it all depends on your trading style, risk tolerance, and your discipline.
My favorite Head and Shoulders pattern
Below you have a chart showing my favorite Head and Shoulders pattern. On first look, you will see a normal Head and Shoulders, but what makes this one special and with a higher winning rate is the bearish divergence between the left and right shoulder. Not many traders aware of this technique. What I want to see is, a right shoulder that is higher than the left shoulder and on the RSI I want to see a bearish divergence between those two shoulders. So I am looking for a right shoulder that is making lower high than the left shoulder in the RSI indicator as shown in the chart below. Entry, target, and stop-loss to be placed as explained above.
Live example on Head and Shoulders with RSI confluence
(Update) This short trade happened today the 11-11-2019. The video is taken from my daily briefing that is sent to our Chat-Room subscribers. Here we see how I was laying out the trade plan to our members, ahead of the break to be prepared for the scenario. The good thing here is that we had the RSI divergence clear on the chart making us more confident about the trade.
Hello traders! In this short video we have a great example on my favorite Head and Shoulders pattren that I mentioned in my latest article. Watch it and also read the article on Head and Shoulders pattern (Link below).The video is taken from the briefing sent to our premium members.https://www.pa-fx.com/2019/10/22/head-and-shoulders-pattern/
Slået op af PA FX i Mandag den 11. november 2019
… And here is the outcome of the trade idea.
Live example on Inverted Head and Shoulders
(Update 14-11-2019) I know that I told you most patterns are easy to see after they happen, but I always try to predict the market’s next move. It’s not that easy, and won’t happen all the time. When you know how to read the market structure, how to read the candles one by one, as I was showing in the video below to my students and subscribers, then you have a bigger chance of getting more winners than losers. Watch the video below and try to understand how I resonated about the trade. I always try to have plan B ready in case I am wrong, which I am, many times. The thing is, that as far as you are not stubborn about your ideas and adabt to what the market is telling you, you’ll be just fine.
A short video from the daily morning briefing that I send to my students and subscribers. I am explaining what to look for, in this case the inverted head and shoulders pattern. At PA-FX you won't get an e-mail with entry and exit levels, what I do is sending out one briefing each morning on more than 25 charts with explanation on what to look for and where. (Outcome in the comment section)www.pa-fx.com
Slået op af PA FX i Torsdag den 14. november 2019
- Review the identification guidelines above.
- Trade the pattern in the direction of the major trend for a better winning rate.
- Choose patterns that happen at high-value areas, pre-planned levels, and strong resistance.
- Tall or narrow patterns perform better than short or wide ones. Avoid patterns that are both short and wide.
- A horizontal or up-sloping neckline are the best ones to trade.
- Head and Shoulders with higher left shoulder perform best.
- Patterns with higher right shoulder than the left shoulder with bearish divergence on RSI have a high winning rate.
Images made with TradingView