Trading The Head and Shoulders Reversal Chart Pattern

Entries, stops and targets for trading the Head and Shoulders Chart Pattern

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Head and Shoulders Pattern - NZD/USD 30 Minute Chart. MetaTrader

The head and shoulders is a technical analysis chart pattern. When the pattern has fully formed it means the prior uptrend is over, and a downtrend is underway. This is why the head and shoulders is called a reversal pattern. Head and shoulders occur in futures, stock and forex markets, across all time frames. 

Identifying a Head and Shoulders Chart Pattern

The head and shoulders pattern is a reversal pattern appearing during an uptrend, and signals the uptrend is likely over.

 

As the price is progressing higher it will create a high point, and then retrace. The price then pushes to a new higher-high, and then retraces again. As the price pushes higher again, it is unable to make it to the level of the last high (creating a lower high point) before falling again. This movement creates three peaks, called the left shoulder, head and right shoulder.

There are also two retracements, or pullbacks, which occur during the pattern--one occurs after the left shoulder and one after the head. The low points of these pullbacks are connected with a trendline, which extends out to the right. This trendline, called the neckline, will be useful when trading the head and shoulders pattern.

The attached chart shows a head and shoulders on an intra-day forex chart, with each part of the pattern labeled.

Ways to Trade a Head and Shoulders Chart Pattern

Since the head and shoulders is a topping pattern, when it completes you'll want to begin focusing on taking short positions.

 

The pattern is considered "complete" when the price drops below the neckline of the pattern. On the attached chart, notice how the price drops below the neckline following the right shoulder. This is called a chart pattern breakout.

The traditional method of trading a head and shoulders topping pattern is to enter a short position when the price breaks below the neckline.

Place a stop loss order on the short position just above the high of the right shoulder.

The neckline works well as an entry point only if the two retracements in the pattern reached similar levels, or the second retracement has a slightly higher-low than the first.

If the the second retracement is lower than the first, the trendline will angle downwards, and therefore won't provide a good entry point. In this case, enter short when the price moves below the low of the second retracement (between the head and right shoulder). Also use this entry point if the second retracement low is much higher than the first. This will result in a neckline which is steeply angled higher, and will be of little use for providing an entry point. 

The head and shoulders chart pattern also provides an approximate target for how far the price could run to the downside once the pattern has completed. Note the high of the head and subtract the low of the retracements. This will give you the "height" of the pattern. For example if the top of the head is $98.50 and the low of the retracements is $94, then the height is $4.50.

Now, subtract the height from the breakout price to attain a profit target. If the breakout price was $94, then target price is $89.50.

The best patterns to trade are when your potential reward, based on the profit target, is at least twice as much as your risk (based on the high of the right shoulder and entry point). In other words, a pattern with a right shoulder that is quite a bit lower than the head provides a better trade setup than a pattern where the right shoulder is almost as high as the head.

Head and Shoulders Chart Pattern - Final Word

The head and shoulders reversal pattern occurs during an uptrend, and marks its potential end. The chart pattern is composed of three peaks, with two retracements in between. The pattern is complete--and provides a potential short entry point--when the price drops below the neckline, or second retracement low. A stop loss traditionally goes above the right shoulder and a target is established based on the height of pattern subtracted from the breakout price.

Ideally the trade should provide a better than 2:1 reward to risk ratio; if it doesn't, consider skipping the trade or only using the pattern for analytical insight. 

There is a also an inverse head and shoulders pattern. It's an upside down version of the above, and marks the end of a downtrend.