Trading the head and shoulders chart pattern in the common way is to treat it as a reversal pattern. It is probably ranked as close in popularity as the various triangle patterns that can be on a chart.
Let’s cover the standard method of trading a head and shoulders chart pattern and then look at a way to “front run” the potential break of the neckline.
What Is A Head And Shoulders Chart Pattern
The pattern is named as such due to the shape the pattern takes that resembles the head and shoulders of a human. There are three peaks with the middle one being the highest and the smaller peaks on each side of the middle peak.
Extending the comparison we have the fourth feature of the pattern, the neckline, formed by drawing a line between the two depressions between the shoulders and the head. Classical technical analysis defines an uptrend as a series of higher highs and higher lows.
This is what we see in this image, a clear uptrend culminating in the head of the pattern.
The right shoulder suggests a weakening of this uptrend because it is the first lower high in the chart. This weakening is further indicated by a new low at the right neckline that is just barely higher, or the same, as the prior low.
Head And Shoulders Can Signal A Trend Reversal
The pattern of higher highs and higher lows is breaking down and suggests that the uptrend is coming to an end. When a trend ends it will inevitably be followed by either a sideways price consolidation or by a trend reversal.
In the case of a head and shoulders pattern the reversal is signaled by price breaking through the neckline.
The neckline of the pattern represents a level of resistance to a downward move in price. Think of it as a resistance level formed by the double bottom inside the head and shoulders formation. Once this resistance level is broken to the downside it becomes support for the downtrend and you will often see price retrace to the neckline before resuming the downtrend.
You want to watch price action at the neckline to see if there will be a failure with this pattern.
The neckline also helps us project the size of the move down which will give you a price target to shoot for. Your price target may not be met but you will have an idea of a potential risk reward for the trade.
You can also split the difference of the price target and use that as a place to tighten your stop or scale out of the trade.
To find your price target, measure the distance from the top of the head to the neckline. This distance is then subtracted from the neckline where price breaks through it to give us a minimum target for the move down.
In our image, the distance between the head and neckline is denoted as A and this is projected down as B which you’ll see was easily reached in the reversing move.
Use Volume To Confirm The Pattern
The head and shoulders pattern is often further confirmed by volume. The left shoulder will typically have strong volume, while the volume at the head will be lower because the uptrend is weakening. The volume at the right shoulder will be weaker still signaling an end to the trend while the break through the neckline will come on strong volume.
This volume pattern is a secondary confirmation however and will not always be there. Rely on the formation of the pattern and the breaking of the neckline to indicate the reversal.
Inverse Head And Shoulders
So far we have only discussed the head and shoulders pattern as indicating a trend reversal from an uptrend to a downtrend. There is also an opposing pattern, the inverse head and shoulders pattern that signals a reversal from a downtrend to an uptrend, and you could even see alternating patterns within a larger time frame consolidation.
Here we have a head and shoulders pattern that is broken to the downside and gives us a target A once the neckline is broken. Price actually retraces to retest the neckline before resuming its downtrend. The downtrend doesn’t last long before an inverse head and shoulders is formed.
This is broken to the upside and measuring the distance from the head to the neckline gives us a target of B, which again is reached after a few tests of the neckline.
Get A Jump On A Trend Reversal
The proper way to trade the head and shoulders pattern is to wait for a break of the neckline which will complete the chart pattern. The problem with this becomes apparent when the size of the head and shoulders pattern is too large. Much of a trade-able move could be long gone before the neckline breaks and even that may not signify a reversal.
What if there was a way to “front run” the neckline break and take advantage of the potential increase in order flow?
I’ve added a horizontal line to our first chart that started at the left shoulder. You can see that price comes close to the horizontal line as it forms the right shoulder.
The good thing about this setup is if the trade fails at the neckline, you will be able to get out of the trade with either a very small loss or a tiny profit. Trading the neckline break has you in a losing trade the moment it crosses back over the neckline.
You’ve also a well defined risk point which is just over the right shoulder.
Chart Patterns Fail
Like all technical analysis patterns the head and shoulder will not always precede a reversal. The pattern can also fail and we typically consider it failed if price breaks above the right shoulder. When that happens we will most likely have entered a consolidation or resumed the uptrend.
The latter would be confirmed by a price break above the top of the head, similarly for the inverse head and shoulders.
It can be difficult at times to spot head and shoulders patterns on a chart, usually because we look for them in the wrong places. You will only find these patterns at the end of a trend so don’t bother looking for them during a price consolidation or in very choppy markets, make sure that there was a clear pattern of higher highs and higher lows first.
As a chart pattern, identifying them can be subjective and that is why I prefer to use the daily chart and above for reversal structures such as the head and shoulders.
Also, don’t force it, don’t squint too hard or try to finesse it too much. When the pattern is there it will be as clear as shown in our examples. Reversals can also be indicated by other technical patterns so don’t assume you’ll find a head and shoulders at every reversal.
Exercise your eyes and mind and start looking for head and shoulder patterns on your charts. Once you spot them make your target projections and see how often they are hit. You may find that this pattern can be a profitable addition to your trading toolkit or at least provide a strong confirmation for reversals signaled by your current trading system.