Head and shoulders patterns and trading charts

What are head and shoulders patterns?

The head and shoulders (H&S) pattern is a technical analysis tool that identifies potential trend reversals in asset prices. Three consecutive crests, the highest in the centre, form a distinct shape resembling a head with two shoulders, resting on a common support known as the neckline. Typically, the pattern is more powerful and occurs after a significant price increase, suggesting a weakening uptrend.

The main components of the H&S pattern can be analysed as follows:

1. A price spike forms the first crest, the left shoulder, and then the price drops back to the neckline.
2. A second crest, the head, is created by a rally that reaches a higher peak before retreating to the neckline.
3. The third crest, the right shoulder, often smaller than the left, indicates declining buying strength.
4. As the trend weakens and the pattern emerges, volume often falls.

Classic head and shoulders pattern

The classic head and shoulders pattern signals a potential trend reversal from bullish to bearish. It's characterised by three high points with a central peak (head) higher than the two outside peaks (shoulders). These peaks rest on a horizontal support or slanted trendline, called the neckline.

A confirmed break below the neckline, ideally with strong trading volume, suggests a price decline. The target projection for this decline is typically the distance between the head and the neckline, although some analysts use the height of the shoulder.

Inverse head and shoulders pattern

The inverse head and shoulders pattern is the opposite of the classic formation, indicating a potential reversal from bearish to bullish. It features a three-valley structure with the centre valley being the lowest. The neckline here is formed by a horizontal resistance or an uptrend line. A confirmed break above the neckline, accompanied by rising volume, suggests a price increase.

Is the head and shoulders pattern reliable?

While the effectiveness of technical analysis patterns is often debated, the H&S pattern has shown promise in research. Studies by Dr. Andrew Lo at MIT and the Federal Reserve Bank of New York found the pattern to be a reliable indicator of potential trend reversals in various markets, including stocks, commodities, and currencies.

Is a head and shoulders pattern bullish or bearish?

The classic head and shoulders pattern is a bearish signal. It suggests that bulls (buyers) who initially drove the price up (left shoulder) become exhausted. They manage to push the price higher again (head) but lack the strength to maintain the rally (right shoulder). A confirmed break below the neckline indicates a potential price decline.

The inverse head and shoulders pattern is the opposite, acting as a bullish signal. Here, bears (sellers) who were driving the price down appear to be losing momentum. A confirmed break above the neckline suggests a potential price increase.

How to identify head and shoulders patterns

Head and shoulders patterns are visually identifiable by their distinct shape. This consists of:

• Three price peaks consisting of a central high point (head) flanked by two lower highs (shoulders).
• A horizontal neckline connecting the lows before and after the head, acting as support (classic) or resistance (inverted).

While the shape is the key identifier, some traders use additional technical tools, like volume confirmation, to strengthen the signal. Volume typically decreases throughout the pattern formation, suggesting weakening momentum behind the price swings.

Confirmation is crucial

While the H&S pattern can be detected as it forms, it is not confirmed until the price clearly breaks below the neckline (classic) or above the neckline (inverted), accompanied by an increase in trading volume. This break points to a potential trend reversal.

Price movement before confirmation may show higher highs and higher lows (classic pattern) or lower lows and lower highs (inverted pattern). The formation of the head (higher high for classic or lower low for inverted) can create a temporary sense of hope for bulls (classic) or bears (inverted). However, the failure of the right shoulder to exceed the height of the head — and possibly even the left shoulder — suggests that the trend might be losing steam. This is where traders must decide whether to stay in or exit their positions.

How to trade head and shoulders chart patterns

Traders use head and shoulder patterns to identify potential trend reversals.

In the classic bearish pattern, traders go short (sell borrowed assets) once the right shoulder is complete and there is a confirmed breach below the neckline with high trading volume. This breakout suggests a decline, and the distance between the head (highest point) and the neckline is a popular target area. For example, if a stock peaked at $100 and had a neckline at $90, its target price would be $80. This is calculated by taking the difference between the peak ($100) and the neckline ($90) and subtracting it from the neckline value again ($90 - $10 = $80).

Beyond the basic target projection, traders look for potential support levels that coincide with other technical indicators, such as moving averages or Fibonacci retracements, to form zones of confluence for a more realistic target. Identifying these levels allows traders to set stop-loss or take-profit targets to manage their risk and adjust their trading strategy.

Similarly, for the bullish inverse pattern, traders go long (buy) after a confirmed break above the neckline with high volume. After determining an initial target zone using the distance between the inverted head (lowest point) and the resistance line, traders look for potential areas of resistance that coincide with other technical indicators.

In either case, whether classic or bearish, it is critical to confirm the validity of the neckline breakout, as ‘fakeouts’, where the price pierces the neckline but quickly reverses, can occur. When a clear break occurs and the price revisits the neckline before continuing in the direction of the break, it can serve as further confirmation, particularly when backed by significant volume, indicating more conviction behind the price movement.

Once the breakout has been confirmed, some traders use limit orders to automate entry and exits. You can place a limit-sell order below the neckline for classic patterns and a limit-buy order above the neckline for inverse patterns. These orders are executed only when the price reaches the specified price level.

Traders should close their positions when they reach or exceed the target zone, or if the price action indicates that a reversal may not occur.

In summary, to trade the H&S pattern:

• Identify the pattern formation with three peaks and a neckline.
• Wait for the neckline breakout and confirm the reversal.
• Establish a potential profit target zone based on a confluence of technical signals.
• Trade in the direction of the breakout (short for bearish, long for bullish).
• Use stop-loss orders to mitigate risk and maximise potential gains.
• Monitor the trade and adjust stops for profit protection.

Advantages of head and shoulders patterns

The H&S pattern appears in a wide range of markets, making it a versatile tool. It is regarded as relatively reliable, providing traders with information on direction and target zones.

Its distinct three-peak structure with a neckline provides clear entry and exit points for trades, allowing traders of all skill levels to spot potential possibilities.

Traders recognising and reacting to the formation can create a self-fulfilling prophecy, which increases the pattern’s validity.

Disadvantages of head and shoulders patterns

Only after the price movement has occurred can we confirm an H&S pattern. As a result, they are also considerably easier to identify in retrospect.

Perfect patterns are rare, as the exact formation can vary depending on shoulder heights and neckline angles. Furthermore, price movements can sometimes penetrate the neckline before reversing quickly (false breakout), leading to misleading signals.

Finally, the pattern does not provide the exact timing of the trend reversal, so traders may miss the entry point or wait too long for confirmation, potentially leading to missed trades.

Conclusion

Head and shoulders (H&S) is a powerful technical pattern that can help traders spot potential trend reversals, making it a valuable tool for their arsenal. Traders may develop a comprehensive strategy by including H&S alongside other technical indicators and remaining up to date on market conditions.

Ready to trade your edge?

Join thousands of traders and trade CFDs on forex, shares, indices, commodities, and cryptocurrencies!

This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.