What is a head and shoulders pattern?

The "Head and Shoulders" pattern is one of the most popular and reliable chart patterns used in technical analysis to predict trend reversals. It typically signals a change from an uptrend to a downtrend, making it a critical pattern for traders to recognize. In this blog, we will explain what the head and shoulders pattern is, how to identify it, and how to use it in your trading strategy.

1. What is the Head and Shoulders Pattern?

The head and shoulders pattern is a chart formation that signals a trend reversal. It consists of three peaks: a higher peak (the "head") between two lower peaks (the "shoulders"). The pattern occurs after an uptrend and suggests that the price is about to reverse direction and head lower, signaling a potential bearish trend. There is also an inverse version of this pattern, known as the "Inverse Head and Shoulders," which indicates a reversal from a downtrend to an uptrend.

The key components of the head and shoulders pattern are:

• Left Shoulder: The first peak forms after a strong uptrend. It is followed by a decline to form the first low.
• Head: The second peak, which is higher than the left shoulder, forms after the first decline. This is followed by another decline to form the second low.
• Right Shoulder: The third peak, which is lower than the head but similar to the left shoulder, forms after the second decline.
• Neckline: A line drawn connecting the lows formed between the head and shoulders. This is a crucial level, and a break below the neckline is seen as confirmation of a trend reversal.

2. How to Identify the Head and Shoulders Pattern?

To identify the head and shoulders pattern, traders should look for the following characteristics:

• Uptrend Before the Pattern: The pattern generally forms after a strong upward trend in the market, so the price is expected to reverse.
• Clear Peaks: The "head" should be the highest point of the three peaks, with the "shoulders" being lower but relatively similar in height.
• Symmetry: The left shoulder and right shoulder should ideally look symmetrical in shape and size.
• Declining Volume: Volume tends to decrease as the pattern develops. It peaks at the head and then starts declining as the pattern completes.
• Break of the Neckline: The most critical part of this pattern is the breakout below the neckline. Once the price drops below this level, it confirms the pattern and suggests that a bearish trend is starting.

3. How to Trade Using the Head and Shoulders Pattern?

Once you identify the head and shoulders pattern, you can take the following steps to trade based on the pattern:

a) Wait for the Break of the Neckline

The most crucial confirmation of the head and shoulders pattern is when the price breaks below the neckline (the support level formed by the lows of the left shoulder and the head). This signals that the price is likely to continue downward, and you can enter a short position or sell your existing long position.

b) Set a Target

To set a price target, measure the distance from the top of the head to the neckline and then subtract that same distance from the breakout point (the point where the price breaks below the neckline). This gives you a projected price target for the bearish move.

c) Place a Stop Loss

To manage risk, place a stop loss just above the right shoulder. If the price moves against the expected direction and breaks above the right shoulder, the pattern is invalid, and you can exit the trade to limit losses.

4. Inverse Head and Shoulders Pattern

The inverse head and shoulders pattern is a mirror image of the regular head and shoulders pattern. It appears during a downtrend and signals a potential reversal to an uptrend. The key difference is that instead of a bearish reversal, the inverse pattern indicates a bullish reversal.

5. Conclusion

The head and shoulders pattern is a powerful tool for predicting trend reversals, particularly after a strong uptrend. By identifying the pattern and using it with other indicators, traders can improve their trading strategies. However, it’s essential to confirm the pattern with other technical analysis tools, such as volume, and manage risk by setting stop-loss levels.