Choosing when to buy and when to sell in a volatile market environment can be a tricky proposition. Whether you’re a stock, Forex, or cryptocurrency trader, it helps to know certain chart patterns and understand how they relate to your individual trading circumstances. By studying these chart patterns you can decode the market psychology, and thereby forecast upcoming price movements on the price chart of various tradable securities. This can save you a lot of time in analyzing the markets, and provide you with a tool to trade them profitably. One popular chart pattern that technical traders rely on for such purposes is the Head and Shoulders Pattern.
So, what does the Head and Shoulders Pattern in technical analysis refer to? The Head and Shoulders Pattern is a reversal chart formation that provides technical traders with a tool to forecast a bullish-to-bearish trend reversal. Structurally, this pattern consists of a baseline with three peaks that resemble the look of a human Head and Shoulders, hence the name.
The capital markets don’t have to be confusing and using chart patterns, such as the Head and Shoulders Pattern, to forecast trends in the market can be a huge boost for any trader, beginner or otherwise. In this article, we will discuss everything you need to know to profitably trade using this pattern, ranging from different ways to identify this pattern to improve its reliability in trading, and more. Therefore, if this popular chart pattern has ever caught your attention, read on and I am sure you will find this article interesting.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
Types of Head and Shoulders Pattern
Chart patterns, also known as price patterns, are an important component of technical analysis. Many technical traders are known to have these patterns at the core of their trading strategy, and heavily depend on them to extract meaningful insights on the market psychology.
Broadly, chart patterns can be classified into two broad categories – the Reversal Chart Patterns and the Continuation Chart Patterns. Reversal Patterns indicate the beginning of a new trend, stepping away from the previous trend. On the contrary, the occurrence of a Continuation Pattern is an indication that the prevailing trend will continue.
Head and Shoulders, in particular, is perhaps the most popularly traded Reversal Chart Pattern. There are two broad variations of this pattern that as a trader you must know –
- Regular Head and Shoulders Pattern
- Inverse Head and Shoulders Pattern
In the following section, we will discuss both these variations of this pattern in some more detail.
Regular Head and Shoulders Pattern
As noted above, Regular Head and Shoulders (commonly referred to as simply Head and Shoulders) is a popular reversal chart pattern that is commonly used in trading. In essence, it predicts a bullish to bearish trend reversal.
- A bull market is a set condition in which prices are either expected to rise or are rising
- A bear market is a set condition in which prices are expected to decline or are steadily declining
Therefore, you can leverage the Head and Shoulders Pattern to identify opportunities to sell or to short-sell the securities that you are trading. By appearance, the pattern consists of three peaks, with the middle peak being the highest among the three. This structure resembles very closely to the shape of a human head and shoulders, and it is this resemblance that gives this pattern its name.
When it comes to identifying bearish reversal or predicting the end of an uptrend, this pattern is beyond doubt a very reliable tool in technical analysis. Hence, once you identify this pattern on the price chart of a security, and the price approaches the bottom of the downslope on the right shoulder, it is a strong indication that you should sell or short-sell the security.
Even though the Head and Shoulders Pattern is a very reliable tool in identifying bearish reversals, its predictive power can be considerably improved by combining it with other complementary indicators and tools. In particular, trading volume forms a very good combination with this pattern. When the price dips below the neckline of the right shoulder and the trading volume is high or above average, the strength of the sell signal indicated by the Head and Shoulders Pattern is considerably bolstered.
Inverse Head and Shoulders Pattern
As the name suggests, the Inverse Head and Shoulders Pattern is the opposite of the Regular Head and Shoulders Pattern. Therefore, this pattern is indicative of a bearish to bullish trend reversal.
By appearance, the Inverse Head and Shoulders Pattern looks like a series of dips, with the head (or the middle dip) being the lowest of all the dips. With this pattern, if the right shoulder starts to form and the price reaches back up to the level of the left shoulder, it is an indication that a bullish move is upcoming and it, therefore, signals a buy or a long trade.
In essence, with an exception to the direction towards which the trend reversal is predicted, the Inverse Head and Shoulders Pattern shares all characteristics with the Regular Head and Shoulders Pattern. Hence, even though this pattern in itself is quite reliable at predicting upcoming bullish reversals, its accuracy can be further improved when combined with other complementary tools and indicators in technical analysis.
Finally, just as with the Regular Head and Shoulders Pattern, you should keep an eye on trading volume when making trade decisions based on the Inverse Head and Shoulders Pattern as well. Price rising above the neckline to form the right shoulder, in combination with high or an above-average trading volume is a strong signal that a bullish price movement is coming.
In the rest of the article, we will primarily focus on the Regular Head and Shoulders Pattern, however, everything that we discuss here is applicable, but in reverse, to the Inverse Head and Shoulders Pattern as well.
Identifying Head and Shoulders Pattern
The Head and Shoulders Pattern is easy to spot on the price chart after the fact, but identifying it in time to make a trading decision can be challenging. Additionally, while the pattern is still in development, it is not uncommon for traders to confuse it with other popular chart patterns, such as the Double Top Pattern. Therefore, your ability to correctly and timely identify this pattern is at the core of successfully trading and profiting from it.
There are two ways that are best used in combination with each other to correctly and timely identify the Head and Shoulders Pattern. These are –
- With Geometry and Shape Recognition
- With the Use of Technical Indicators and Tools
In the following sections, we will discuss both these approaches to identifying the Head and Shoulders Pattern.
Identifying Head and Shoulders Pattern Using Geometry and Shape Recognition
Structurally, the Head and Shoulders Pattern consists of three peaks and a neckline. Described below are each of these four components of this pattern –
- The Left Shoulder: The Left Shoulder forms the first peak of the Head and Shoulders Pattern. Overall, this component of the pattern comprises two broad phases – the bullish phase and the retracement phase. The bullish phase of the Left Shoulder is marked by a surge in trading volume and is simply an extension of the existing uptrend, under which the price of the security reaches a new high. Contrarily, in the retracement phase of the Left Shoulder, the trading volume takes a dip and the price pulls back from its new formed high.
- The Head: The Head forms the second and the highest peak of the Head and Shoulders Pattern. Similar to the Left Shoulder, even the Head of the pattern consists of the bullish and the retracement phase. During the bullish phase of the Head formation, the price of the security hits yet another high, and this upward move is coupled with another surge in trading volume. This formation of a new high is followed by a decline in trading volume and yet another retracement, completing the formation of the Head of the pattern.
- The Right Shoulder: The Right Shoulder forms the third and the final peak of the Head and Shoulders Pattern. Similar to the Head and the Left Shoulder, the Right Shoulder is also formed in two phases. During the first or the bullish phase of the Right Shoulder, the trading volume sees yet another surge, but this surge is not enough to make another high. Finally, the price falls to the neckline with a reduced trading volume, marking the completion of the overall Head and Shoulders Pattern.
- The Neckline: The Neckline is another integral component of the Head and Shoulders Pattern. In essence, it is a straight line connecting the dips between the two shoulders and the head. In trading the Head and Shoulders Pattern, the Neckline plays a critical role in determining the entry points for the short or the short-sell trades. When the Neckline intersects the price series after the Right Shoulder, it signals a further decline in price, and this is the time when you would execute a short trade.
Now that we have discussed various structural components of the Head and Shoulders Pattern, let us discuss several important characteristics of this pattern that are critical to identify it correctly as well –
- The Head of the pattern should be taller than the shoulders.
- The tops and bottoms of the two shoulders should be around the same height.
- The overall pattern should be fairly symmetric, leading to the Head and Shoulders appearance.
- Of the three peaks, the surge in trading volume must be highest during the formation of the Left Shoulder, and lowest during the Right Shoulder formation.
Identifying Head and Shoulders Pattern Using Technical Indicators and Tools
There’s an important difference between technical analysis and the more widely used fundamental analysis. Technical analysis relies on visual cues, whereas the fundamental analysis relies on financial data and algebra. Hence, pattern recognition through visual cues play a critical role in the successful implementation of technical analysis.
There are several tools in technical analysis that can provide you such visual cues in identifying the Head and Shoulders Pattern. The most popular of these tools are described as follows –
- Price Action Structures: Price action structures are simple markings, such as trendlines, traced on the price chart of a security. Even though it is easy for a seasoned pattern trader to identify a Head and Shoulders Pattern readily, most technical traders can benefit from drawing lines to make in-development patterns more recognizable visually. More than anything else, with such markings on the price chart, it becomes really easy to spot if the pattern in review meets all characteristics of the true Head and Shoulders Pattern.
- Volume Indicators: As discussed in the previous section, there is a strong correlation between the development of the Head and Shoulders Pattern and the variations in trading volume. Each peak of the pattern – the Left Shoulder, the Head, and the Right Shoulder – is characterized by an initial surge in trading volume, which is followed by a period of lower trading volume. Furthermore, during the formation of the Head and Shoulders Pattern, the trading volume is the highest when the Left Shoulder develops and it is the lowest during the Right Shoulder’s formation. Therefore, monitoring trading volume can provide you with a reliable method to verify a Head and Shoulders Pattern on the price chart of a security. Examples of volume indicators that can be used for this purpose include – ADX (Average Directional Index), Volume Price Trend (VPT) Indicator, etc.
Interpreting the Head and Shoulders Pattern
Through its price peaks and valleys, the Head and Shoulders Pattern can sure send a novice trader on an emotional roller coaster. Therefore, to confidently trade this pattern, it is important that you understand the market forces behind its formation.
For that reason, in this section, we will discuss the market forces that lead to the development of the Head and Shoulders Pattern. Described below is the state of the market psychology that results in the development of every component of the pattern –
Interpreting the Left Shoulder of the Pattern
The Left Shoulder of the pattern begins to form in an upward trending market. During the initial development of this phase, the market sentiment for the security is extremely positive and the buyers (or the bulls) have complete control over the market.
As a result, the price of the security continues to rise until the top of the Left Shoulder is reached since there are buyers available in the market to pay the premium price for the security. This phase is also characterized by a period of high trading volume, as more and more buyers continue to enter the market until that top of the shoulder is reached.
Once the top of the Left Shoulder is formed, many buyers who had entered long trades previously begin to book profits by selling their positions. At this point, some short-sellers also enter the market in anticipation of profiting from a downtrend in the security with the assumption that the security’s price has topped.
Hence, the selling pressure on the security increases a bit and the overall trading volume that had been in the buyer’s control takes a dip. This market behavior results in a period of lower trading volume, in which the security’s price continues to drop, leading to the completion of the Left Shoulder of the pattern.
Interpreting the Head of the Pattern
Post completion of the Left Shoulder of the Head and Shoulders Pattern, the price reaches a point where it becomes appealing to the buyers for the security once again.
Therefore, at this stage, a number of buyers once again enter the market. Some of these buyers are the ones that had missed the previous bullish rally in the security, and some of these buyers are simply adding to their already open buy positions. Many short-sellers also begin to close their trades for profit at this stage as well. Therefore, at this stage, the overall buying pressure on the security sees a considerable surge.
As a result of these above-discussed market forces, the price of the security begins to rise once again and forms yet another high surpassing the highest price point reached during the development of the right shoulder.
Naturally, the overall trading volume also rises with the increase in price as this new high is reached. However, it is worth noting that during this phase, the surge in overall trading volume is not as significant as it was during the development of the Left Shoulder. This is because, during the development of the Left Shoulder, there was relatively more optimism and buyers for the security.
During the formation of the Head, as the price rises higher and higher, fewer and fewer buyers are present in the market to pay the premium price for the security. When the security becomes completely overbought and there are no more buyers in the market for it, the top of the Head is reached and the sellers or short-sellers regain control of the market.
Consequently, the trading volume of the security takes a hit and the price begins to decline, thereby completing the Head formation of the pattern.
Interpreting the Right Shoulder of the Pattern
Once the construction of the Head is complete, the price has fallen to the Neckline. At this price point, the buyers for the security make one last attempt to take the price of the security to yet another high but fail.
The attempt of the buyers to take the price higher results in a slight boost in the trading volume, which quickly dies down once the top of the Right Shoulder is reached. Hence, the increase in the price attained during this last push also gets flushed away and the price returns to the neckline and breaks beyond it, marking the completion of the Head and Shoulders Pattern structure.
At this point, the sellers are in complete control of the market, and this increased selling pressure is expected to take the price of the security further down. Hence, once the construction of the Head and Shoulders Pattern is complete, traders look for a breakout sell trade, in anticipation to profit from a sudden downtrend move.
How Reliable is Head and Shoulders Pattern in Trading?
The reliability of the Head and Shoulders Pattern has long been a topic of discussion. Despite being one of the most popular and widely traded chart patterns, the pattern has received its fair share of criticism.
So, how reliable is the Head and Shoulders Pattern in trading? Not very. The Head and Shoulders Pattern provides an effective description of market psychology but it comes with a lot of subjectivity. Therefore, as a standalone analysis tool, the pattern is not very reliable. That being said, when combined with various complementary indicators and tools, the Head and Shoulders Pattern does provide traders with a considerable edge in trading.
For a trading system or pattern to be effective as a standalone indicator, it is necessary that the system is objective and mechanical. When relying solely on the Head and Shoulders Pattern, it is easy for traders to lose that objectivity.
Besides losing that objectivity, it is also very common for traders to make the below listed mistakes when trading the Head and Shoulders Patterns that further impact the pattern’s reliability –
- A failure to incorporate sound risk management techniques
- A failure to incorporate stop loss orders with initial orders
In the following sections, we will discuss how you can objectively trade the Head and Shoulders Pattern by combining it with signals from other complementary indicators. Additionally, later in the article, various strategies to trade this pattern, along with proper risk management and stop loss setting guidelines are also discussed.
Improving Reliability of Head and Shoulders Pattern
Even though the Head and Shoulders Pattern is not very reliable in trading when used as a standalone analysis tool, its reliability can be considerably improved when used in combination with other complementary tools. Additionally, with proper risk management and a well-defined trading strategy, you can make sizable profits with a favorable trade success ratio when trading this pattern.
There are numerous analysis methods and tools in technical analysis that are complementary to the Head and Shoulders Pattern and can considerably improve this pattern’s accuracy. The most popular of these complementary tools are listed as follows –
- Japanese Candlesticks
- Support and Resistance
- MACD
- Volume
Now, in the following subsections, let us briefly discuss what these above-listed tools are and how you can effectively integrate them with your Head and Shoulders Pattern trading strategy to sizably improve the accuracy of your trades.
Japanese Candlesticks
Originally developed in Japan in the 18th century, Japanese candlesticks have become popular in the West as a tool of technical analysis.
Japanese candlesticks are formed using four prices:
- Open – the opening price for the trading session
- High – the highest price for the trading session
- Low – the lowest price for the trading session
- Close – the closing price for the trading session
These four prices are used to make up the body of the candlestick, giving analysts a single figure for each session’s trading. It presumes that, over a period of time, Japanese candlesticks can be used to easily view, in one single graph, trading trends of a particular security.
If the candle is black or red, it indicates that the price closed below the opening price. Similarly, if the candle is white or green, it is an indication that the price closed above the opening price. The “wicks” on both ends of the candle represent the trading sentiment before the trading session’s settlement. Japanese candlesticks represent supply and demand and can, therefore, tell an analyst quite a bit about past trading.
A limitation of candlesticks is that they do not provide potential price targets. However, by combining Japanese candlesticks with the Head and Shoulders Pattern in trading, you can get confirmation on your trade entries and exits.
Described below is how you would use the Candlestick Patterns to bolster the trade signals from the Head and Shoulders Pattern –
- Identifying Reversals: When used with the Head and Shoulders Pattern, candlesticks can provide a confirmation on an upcoming reversal in price trend. Particularly, the Reversal Candlestick Patterns can come in really handy for this purpose. In scenarios when there are no Reversal Candlestick Patterns on the price chart to confirm a reversal trade entry, you must research further before finalizing any reversal trade decisions.
- Confirming Breakout Trades: Breakout Trading is a popular strategy to trade the Head and Shoulders Pattern that technical traders implement. While this trading strategy can be very effective, false breakouts are a common occurrence. Therefore, to improve the reliability of this trading strategy, you can leverage the Continuation Candlestick Patterns to confirm breakouts before entering a trade using them.
Support and Resistance
One popular and perhaps the most fundamental, tool in technical analysis to identify potential reversal zones on the price chart of a security is the concept of Support and Resistance. There are many different types of Support and Resistance zones. These include – Horizontal Support and Resistance Levels, Trendlines, Trading or Price Channels, Pivot Points, Fibonacci Retracement and Extension Levels, etc.
In a nutshell, the Support represents the zone of high demand or buying pressure for the security, whereas the Resistance represents the high supply or selling pressure zones. The bottom of the trading range is the support line. It tells where the trend is likely to stop and, perhaps, reverse. It’s essentially the lowest price that is likely to be reached. The resistance line is the opposite, in that it is the top of the trading range. It, in essence, is the highest price that most buyers would consider paying.
Generally, these levels are marked on the price chart using horizontal lines or trendlines, and the region between these lines forms a trading range and is referred to as the consolidation or the stabilization zone.
As discussed above, one key limitation of trading the Head and Shoulders Pattern is the lack of objectivity in determining the reversal points. This is where the Support and Resistance can help close the gap. When a Support or Resistance level is tested, prices of the security can do one of three things:
- Hold
- Bounce back up or Reverse down
- Breakout of the support or the resistance zone
When used in conjunction with the Head and Shoulders Pattern, depending on the price wave within the pattern structure that you intend to trade, the awareness of these above-listed possibilities can considerably improve the accuracy of your trades. Hence, the Support and Resistance levels can help improve the reliability of the Head and Shoulders Pattern by adding some objectivity to the trading decisions made using it.
MACD
MACD stands for Moving Average Convergence Divergence. It is a technical indicator that, in essence, shows the relationship between two moving averages of a security’s price. Under standard indicator settings, these two exponential moving averages are the 26 period and the 12 period moving averages.
MACD, as a technical indicator, incorporates trend and momentum in a single view, making it a powerful tool for pattern traders. When trading using this indicator, if the MACD crosses the zero line upward, it is an indication that there is a buy opportunity. Conversely, whenever the MACD crosses the zero line downward, it indicates a sell opportunity.
When used in combination with the Head and Shoulders Pattern, the MACD indicator can help improve the accuracy of your trades in the following ways –
- When you see the Head and Shoulders Pattern on a MACD chart, it confirms the underlying principle that the price trend is about to be reversed.
- When an Inverted Head and Shoulders Pattern is seen on the MACD chart, the price trend is again about to be reversed, this time in an upward direction.
- If there is Divergence on the MACD chart with respect to the price trend, it represents the weakness in the momentum. Such Divergence readings can be used as a confirmation sign for an anticipated reversal identified using the Head and Shoulders Pattern.
In summary, MACD is another tool in your trading arsenal that lets you confirm if a reversal is about to occur. Based on this confirmation signal, you can take a more informed buy or sell decision. Using multiple tools in technical analysis is one way to double-check your theories and make the correct trading decision, and you should almost never rely on the trading signals from any one indicator.
Trading Head and Shoulders Pattern
Just as with any other chart pattern, there are several strategies that you can use for trading the Head and Shoulders Pattern. Depending on your trading psychology, risk appetite, and temperament, the ideal choice of trading strategy for you can vary.
The most popular and reliable trading strategies for the Head and Shoulders Pattern are as follows –
- The Breakout Trading Strategy
- The Buildup Trading Strategy
- The First Pullback Trading Strategy
Now, without further ado, let us discuss each of these three trading strategies with necessary details.
Trading Strategy 1: Breakout Trading Strategy
The Breakout Trading Strategy is the most common and the most popular way to trade the Head and Shoulders Pattern. In this strategy, a trade is made when the breakout occurs – when the neckline is broken and the Right Shoulder is completely formed.
For the Head and Shoulders Pattern to completely form on the price chart of a security, it takes nearly 150 trading sessions. Therefore, when trading breakouts, the accuracy of your trades would be much higher for patterns that take a similar number of trading sessions to completely form.
With the Breakout Trading Strategy, there are four stages involved in making a profitable trade. These are –
- Identifying Tradable Wave
- Determining Trade Entry
- Determining Stop Loss Target
- Determining Take Profit Target
In the following sections, we will briefly discuss each of these four stages, so that you can confidently start taking breakout trades using the Head and Shoulders Pattern in no time.
Identifying Tradable Wave
Prices move in somewhat predictable waves. Broadly, there are two types of price waves that you will find on the price chart of any security. These are –
- Impulse Waves: These waves represent large price movements in a relatively short period of time.
- Corrective Waves: Contrary to the Impulse Waves, these waves represent relatively smaller price movements over an extended period of time.
With the Breakout Trading Strategy, the focus is always on capturing an impulse wave during its initial development phase. The objective here is to profit from the sudden price movement and exit the trade for profit with a relatively small holding period.
When trading breakouts using the Head and Shoulders Pattern, the impulse wave that is targeted to short-sell is the one that emerges after the neckline is broken below the Right Shoulder of the pattern.
In the case of an Inverse Head and Shoulders Pattern, you will target the same wave, the one that emerges once the neckline breaks post-formation of the second shoulder, but for a bullish trade.
Determining Trade Entry
As discussed above, with the Breakout Trading Strategy for trading the Head and Shoulders Pattern, an entry signal for a bearish trade is triggered when the pattern neckline is broken by the price movement, after the formation of the pattern’s Right Shoulder.
You can plot the pattern’s neckline on the price chart of a security using simple Price Action Structures, such as trendline.
That being said, even though simple Price Action Structures are sufficient at helping traders identify the breakout points, the accuracy of breakout trades can be considerably improved by leveraging more advanced complementary tools as confirmation signals for such trade entries. In particular, tools, such as Divergence and Candlestick Patterns, have been found to work great for confirming breakout trades with the Head and Shoulders Pattern.
Determining Stop Loss Target
On relative terms, the Breakout Trading Strategy is considered very reliable to trade the Head and Shoulders Pattern. But, just as with other chart patterns, false breakouts frequently occur post the formation of Head and Shoulders as well. Therefore, it is important that you minimize your exposure by setting stop loss at a price point where the targeted breakout trade gets invalidated.
With the Head and Shoulders Pattern, a breakout trade is invalidated, if the price bounces back above the neckline after briefly breaking past it.
Therefore, when trading conservatively, you should put your stop loss just a few points above the neckline of the pattern. For more aggressive trading, you can also choose to place the stop loss for your breakout trades a few points above the Right Shoulder.
Determining Take Profit Target
With the Breakout Trading Strategy for the Head and Shoulders Pattern, the key idea on which most Take Profit Target decisions are made is as follows –
- Once breakout from the neckline occurs, the price will move a distance that is at least equal to the distance between the neckline and the top of the Right Shoulder.
Therefore, if you have access to the historical and current price information, and you know the breakout level, factoring Take Profit targets for your trades is pretty straightforward with this pattern. Hence, under this strategy, you have a clear idea of when a trade should be closed for profit.
Finally, using the above-stated idea as a foundation, below is how you will calculate the Take Profit Target when trading breakouts using the Head and Shoulders Pattern –
- First, calculate the difference between the lowest point (neckline) and the highest point of the Right or the Second Shoulder of the pattern.
- Then, subtract this above calculated difference from the price point at which the breakout occurs. The new calculated price point is where you should set the Take Profit target for your short-sell trade.
Trading Strategy 2: Buildup Trading Strategy
The Buildup Trading Strategy for trading the Head and Shoulders Pattern is very similar to the Breakout Trading Strategy, with one minor variation. In this strategy, instead of entering a trade right at the breakout, you wait for the market to form a tight consolidation near the neckline.
With this, you are basically trying to get a confirmation signal that the price would continue on its newly set bearish trajectory and that it is not a false breakout that you are dealing with. Additionally, with this strategy, you also get some additional time in making a trade decision and you are not required to rush into a trade the moment the breakout occurs.
Similar to the Breakout Trading Strategy, there are four stages for making a profitable trade using the Buildup Trading Strategy. These are –
- Identifying Tradable Wave
- Determining Trade Entry
- Determining Stop Loss Target
- Determining Take Profit Target
In the following sections, let us discuss each of these four stages with regards to the Buildup Trading Strategy.
Identifying Tradable Wave
High level, with the Buildup Trading Strategy, you are focused around trading the same wave as with the Breakout Trading Strategy, but with one minor adjustment. That is, instead of trading the entire price wave that emerges after the breakout occurs, you trade only a portion of it.
Below is how you would identify the tradable wave for trading the Head and Shoulders Pattern using the Buildup Trading Strategy –
- First, wait for the breakout from the neckline to occur post the formation of the Right Shoulder of the pattern.
- Next, allow for the price to consolidate post this breakout.
- Finally, trade the portion of the wave that occurs after the price consolidation is over and when the price continues its downward trajectory.
Determining Trade Entry
As mentioned above, with the Buildup Trading Strategy, you wait for the price to consolidate after the breakout before entering the trade. There are several methods that you can use to determine your exact trade entry points using this strategy. These are –
- Using Continuation Chart Patterns: Identifying Continuation Chart Patterns (such as – the Flags, Triangles, Pennants, etc.), on a smaller time frame, provide a great way to enter trades using the Buildup Trading Strategy. Price consolidation post-breakout takes the shape of one such continuation pattern. Therefore, you can leverage trading strategies specific to these continuation patterns for making your trade entry decisions.
- Using Volume: Price Consolidation post-breakout is marked by a phase of low trading volume. When the consolidation is over and the price continues its downward trajectory, the trading volume picks back up. Hence, with this strategy, you would enter a short-sell trade when the trading volume picks back up, after a brief period of momentary reduction.
Determining Stop Loss Target
At a high level, with the Buildup Trading Strategy, you would put your stop loss just a few points above the high of price consolidation. However, depending on your trade entry method (described above), the determination of your stop loss target with this strategy can greatly vary.
Just as with the Head and Shoulders Pattern, there are several different ways in which you can trade various continuation patterns, such as the Flags, the Pennants, etc. Therefore, the stop loss setting criteria for the buildup trades that you take under this strategy can greatly vary.
Hence, to conclude, when trading with the Buildup Trading Strategy, your stop loss determination will be driven by your trade entry strategy.
Determining Take Profit Targets
With the Buildup Trading Strategy, your target for exiting the trade for profit remains the same as with the Breakout Trading Strategy.
Hence, you would exit your trade at the price point that is at the same distance from the neckline as is the top of the Right Shoulder. To calculate this Take Profit target, you can leverage the same steps that are described for the Breakout Trading Strategy.
Trading Strategy 3: First Pullback Trading Strategy
The First Pullback Trading Strategy, in essence, is a hybrid of the Breakout Trading Strategy and the Buildup Trading Strategy.
Post formation of the Head and Shoulders Pattern, when Breakout occurs, the price movement can sometimes be so aggressive that the market never rests for the Buildup or consolidation to occur. In scenarios such as these, if you wait for the price to consolidate, you might miss out on the entire price move.
But, entering trades right at the breakout point, without any reliable confirmation sign for the continuation, is also not ideal. This is where the First Pullback Trading Strategy comes into play and provides a middle ground.
In the First Pullback Trading Strategy, instead of waiting for a big price consolidation, you enter a short-sell trade when the first pullback happens.
At its core, a pullback is a temporary reversal in the price action. Irrespective of how strong the price moves after the breakout, it rarely falls in a straight line. Therefore, there will always be few pullbacks before the downtrend that triggered after the completion of the Head and Shoulders Pattern comes to an end.
Consequently, with this strategy, you will have more trading opportunities than the Buildup Trading Strategy. Additionally, the accuracy of the trades that you take with this strategy is also higher than simply entering trades when the breakouts first occur. Hence, this trading strategy gives you a happy balance between the Breakout Trading Strategy and the Buildup Trading Strategy.
That being said, there are several limitations of trading using this particular strategy as well. These are –
- First, the pullbacks are short-lived and their timing is unpredictable. Therefore, to enter trades using them, you have to be on your toes and monitor the price chart in real-time regularly.
- Second, entering a trade using pullbacks is like catching the falling knife. The strategy for sure is more reliable than taking a breakout trade directly, but the accuracy of the trades identified leveraging this strategy is considerably lower in comparison to the Buildup Trading Strategy.
Now that we have discussed how the First Pullback Strategy is different from the two strategies described above, let us very briefly discuss four stages of trading using this strategy.
Identifying Tradable Wave
The First Pullback Trading Strategy, similar to the Breakout and the Buildup Trading Strategy, focuses on the bearish price wave that forms after the price breaks out of a completed Head and Shoulders Pattern.
In this strategy, you don’t avoid trading the initial price movement post-breakout as you do with the Buildup Strategy. Instead, in case there is a brief pullback before the price consolidates, you will go ahead and enter a trade with the First Pullback Strategy.
On the flip side, with the First Pullback Strategy, unlike the Breakout Trading Strategy, you won’t enter a trade immediately after the breakout occurs. Instead, you will allow the price trend to first develop and pull back before pulling the trigger on any trade decision.
Determining Trade Entry
As stated above, when trading the Head and Shoulders Pattern using the First Pullback Strategy, before entering a short-sell trade post-breakout, you wait for the price trend to develop and pull back.
But, identifying the pullbacks in the realtime can be tricky. Hence, you can leverage the below-stated recommendations to tackle this task –
- When pullbacks occur, price typically pulls back up to an important resistance level on the price chart of the security. Therefore, leveraging the concept of Support and Resistance and plotting resistance levels on the price chart can offer significant help at entering trades using this strategy.
- Generally speaking, on the time axis of the price chart, there are phases of aggressive price movements and corrections. By looking for the correction phase, and timing your trade entry to coincide with it, you are likely to make more accurate trade entries using this strategy.
Determining Stop Loss Target
With the First Pullback Trading Strategy, you can put the stop loss for your trades using the following guidelines –
- For conservative trading, you would put your stop loss a few points above the highs of the pullback.
- For more aggressive trading, your stop loss can be put a few points above the neckline of the Head and Shoulders Pattern.
Determining Take Profit Target
With this trading strategy, calculations for your take profit target remains the same as with the Breakout and the Buildup Trading Strategies. Hence, described below are the two steps involved in calculating the take profit target with the First Pullback Trading Strategy –
- First, calculate the difference between the neckline and the top of the Right Shoulder of the pattern.
- Then, mark the level on the price chart that is at the same distance, as calculated above, but below the neckline. This would be your Take Profit target with this trading strategy.
Advantages and Limitations of Trading the Head and Shoulders Pattern
Similar to any other chart pattern or trading concept in technical analysis, the Head and Shoulders Pattern comes with its own set of advantages and limitations.
For making informed trading decisions based on this pattern, it is important that you understand these pros and cons, and that you factor them into your overall trading strategy.
Hence, in the following sections, we will discuss a few important advantages and limitations of trading this pattern.
Advantages of Trading Head and Shoulders Pattern
- For experienced traders, the Head and Shoulders Pattern is relatively easy to spot and hence trade, on the price chart of a security.
- The pattern is applicable in all security markets and is therefore relevant for all technical traders, irrespective of the asset class they trade.
- For the most part, popular strategies to trade the Head and Shoulders Pattern recommend clear and objective Take Profit and the Stop Loss levels. Hence, when trading this pattern, your risk exposure is well defined.
- Statistically, the Head and Shoulders has been found to be more accurate and reliable than most other price action structures and chart patterns.
Limitations of Trading Head and Shoulders Pattern
- For new traders, the Head and Shoulders Pattern can be a bit tricky to spot on a security’s price chart.
- The price can often pull back and retest the neckline before continuing its downwards trajectory. Therefore, in trading this pattern, there can be situations where you are taken out of the trade, despite the price eventually moving in your anticipated direction.
- The risk-reward ratios with trading the Head and Shoulders Pattern are not always favorable.
- Similar to most other chart patterns, this formation is purely based on historical price information. And, as you would already know, historical price movements do not guarantee the future performance of an asset.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
- Roadmap to Becoming a Consistently Profitable Trader: I surveyed 5000+ traders (and interviewed 50+ profitable traders) to create the best possible step by step trading guide for you. Read my article: ‘7 Proven Steps To Profitable Trading’ to learn about my findings from surveying 5000+ traders, and to learn how these learnings can be leveraged to your advantage.
- Best Broker For Trading Success: I reviewed 15+ brokers and discussed my findings with 50+ consistently profitable traders. Post all that assessment, the best all round broker that our collective minds picked was M1 Finance. If you are looking to open a brokerage account, choose M1 Finance. You just cannot go wrong with it! Click Here To Sign Up for M1 Finance Today!
- Best Trading Courses You Can Take For Free (or at extremely low cost): I reviewed 30+ trading courses to recommend you the best resource, and found Trading Strategies in Emerging Markets Specialization on Coursera to beat every other course on the market. Plus, if you complete this course within 7 days, it will cost you nothing and will be absolutely free! Click Here To Sign Up Today! (If you don’t find this course valuable, you can cancel anytime within the 7 days trial period and pay nothing.)
- Best Passive Investment Platform For Exponential (Potentially) Returns: By enabling passive investments into a Bitcoin ETF, Acorns gives you the best opportunity to make exponential returns on your passive investments. Plus, Acorns is currently offering a $15 bonus for simply singing up to their platform – so that is one opportunity you don’t want to miss! (assuming you are interested in this platform). Click Here To Get $15 Bonus By Signing Up For Acorns Today! (It will take you less than 5 mins to sign up, and it is totally worth it.)
Conclusion
When correctly traded, the Head and Shoulders Pattern is a very useful tool for technical traders, and can considerably help in reaping high rewards or staving off future losses. Chart Patterns, in general, can be invaluable in helping traders predict the future market trends as well. However, there are several pointers that you should remember for trading these patterns profitably.
In trading various chart patterns, including the Head and Shoulders Pattern, traders rely on three main assumptions. When trading these patterns, it is critical that you don’t lose sight of these assumptions and that you bake them into your overall risk management plan. These assumptions in reference are –
- Market action discounts everything
- Prices move in trends
- History repeats itself
Beyond these above-stated assumptions, there are some other foundational pointers that you must consider when trading the Head and Shoulders Pattern as well. These include –
- Volume must confirm the trend
- A trend is in effect until it gives definite signals that it has reversed
- The market is more psychological than logical
Finally, when trading the Head and Shoulders Pattern, you must always remember to use other complementary tools to confirm the pattern and your suppositions. These include volume, other technical indicators, and several advanced concepts in technical analysis such as Divergence. Additionally, you should always set the stop losses for your trades in an informed manner and pay attention to the markets for profitable trading.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
Affiliate Disclosure: We participate in several affiliate programs and may be compensated if you make a purchase using our referral link, at no additional cost to you. You can, however, trust the integrity of our recommendation. Affiliate programs exist even for products that we are not recommending. We only choose to recommend you the products that we actually believe in.
