Head and shoulders is one of the most popularly used candlestick patterns for identifying trend reversals. Spotting a trend revseral is very important for traders. This is because the beginning of a reversal can be:

The ideal entry point for an asset – Traders who do not have positions in the asset can get into a trade just before a trend begins and maximise profits.
The best exit point for an asset – Traders who have positions in the asset can get out at just the right time to maximise profits.

The popularity of head and shoulders is driven by the fact that it tests the strength of the existing trend before the reversal is confirmed. This guide to trading with the head and shoulders pattern covers identifying the pattern, timing entry and exit, and setting risk levels for effective trading.

What is the Head and Shoulders Pattern?

The head and shoulders pattern has two versions:

The bearish reversal – This one looks like an ‘M’ and helps identify the beginning of a bearish trend.
The bullish reversal – This is also called the inverse head and shoulders pattern and looks like a ‘W’. It helps spot the beginning of a bullish trend.

Image Source:https://www.thinkmarkets.com/getmedia/2ef0eec0-543c-44cd-bdb3-6fe3980aedc0/Inverse-head-and-shoulders-pattern.jpg.aspx

The head and shoulder (H&S) pattern occurs when market participants supporting the trend try to test the resistance (in an uptrend) or support (in a downtrend) but fail to breach the level, due to strengthening opposing forces that finally succeed in reversing the trend.

The H&S or inverse H&S pattern have three main parts:

Head: It is the highest peak (in an uptrend) or the lowest valley (in the inverse version) formed in the middle of the pattern.
Shoulders: The lower peaks or valleys on either side of the head are the left and right shoulders. These occur at close price levels distant from the tip of the head.
Neckline: This is the trendline on which all the peaks and valleys rest. It is a critical level to mark the beginning of the trend in the opposite direction.

Trading Strategy: Using Head and Shoulders for Bearish Reversal

For trading with head and shoulders, it is critical to identify the pattern and set the potential entry and exit points precisely. Here are the steps to follow:

First, traders need to identify the neckline for the pattern. It works as the trigger level for the pattern. Typically, the neckline is not a horizontal line but a line along the slope of the ongoing trend. In the case of an uptrend, it is usually an inclined line.

Next, traders identify a peak that is preceded by a shorter peak. The H&S pattern is usually formed when the second peak (head) is twice the height of the first peak (left shoulder) from the neckline.

After confirming the left shoulder and head, traders look for a weakness in the uptrend. It is verified when the bottom after the head falls below the neckline, i.e. it should breach the neckline considerably.

The next peak (the right shoulder) is shorter than the head. It should cross over the neckline, but the peak should not be higher than the left shoulder.

Image Source:https://dailypriceaction.com/blog/head-and-shoulders-pattern/

The price falls below the neckline one more time, to mark the beginning of the downtrend. This point, where the price declines after the right shoulder breaks out below the neckline, is called the breakout point.

The price may then test the neckline one more time before it finally bounces off it, confirming the downtrend.

If the second test after the right shoulder does not occur, traders believe that the bears are much stronger than the bulls. However, if the second test is able to breach the neckline, the downtrend is considered weak and has a chance of relapsing.

Taking Positions after Confirming H&S Reversal

At the final breakdown of the price below the neckline, traders enter short positions.
The optimal place for the stop loss is a little higher than the peak of the right shoulder.
The take profit level is set equal to the size of the head below the neckline. That means, traders expect the price to decline at least as much from the neckline as the height of the head. This is known as measure twice, sell once.
Traders keep an eye on price charts to establish new support and resistance levels to identify their exit points.

Mistakes to Avoid

Remember, no indicator is perfect. Being cautious of where an indicator may fail is essential for mastering the trading strategy with this pattern.

Incorrect Assertion

It is important to know that the H&S pattern will occur only after the momentum of the ongoing trend is exhausted. A common mistake that traders make is forgetting that these are trend reversal patterns and always occur at the end of a trend. Therefore, it is necessary that the market has a sustained prior trend before one of the two patterns can conclude a reversal.

False Signal

Sometimes a trend may weaken for a while, after demonstrating H&S, and subsequently continue. Traders can use other indicators to determine such false signals.

Trade H&S Like a Pro

Often when a new trend sets in, it continues further than just the height of the head. When this happens, traders can use trailing stop loss to capitalise on trend continuation.
When a trend is reversed, it may continue for a while. As the market cycles back, the previous trend may be repeated, after the second reversal. Traders can identify the point of inflection for the next reversal by drawing an extended trendline from the head to the right shoulder.

Image Source:https://forextraininggroup.com/wp-content/uploads/2016/11/Head-and-ShouldersTrading-Example-2.png

Image Source:https://forextraininggroup.com/wp-content/uploads/2016/11/Inverted-Head-and-Shoulders-Trading-Example.png

A popular way of confirming the reversal is noting what happened historically. In case of a bearish reversal, there should not be any high upswings in the price just before the formation of the pattern. The price chart should appear in a clean uptrend. Also, the shoulders should be roughly on the same horizontal plane.

To Sum Up:

The head and shoulders pattern has three main parts - head, neckline, and left and right shoulders.
Trade H&S only after the pattern has been completed, after a sustained trend.
Remain cautious of picking up false signals. It’s best to trade only after confirming the pattern with other indicators.
The stop loss can be a little higher than the peak of the right shoulder.
Traders may use the height of the head to set the take profit price and the slope of the head and right shoulder to speculate the next trend reversal.

Disclaimer:

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