Head and Shoulders Chart Pattern in Technical Analysis
By Stelian Olar, Updated on: Nov 29 2023.
Have you ever noticed a head and shoulder pattern forming on a stock chart and wondered - what does this mean and how can I trade it? If so, you've come to the right place. The head and shoulders pattern is one of the most widely followed and traded chart formations among technical analysts and traders.
As a trader, being able to recognize these chart patterns can give you a huge advantage. If you want to up your trading game, you'll need to get familiar with how to spot this powerful formation.
In this article, we'll break down:
- What does a head and shoulders pattern mean.
- How to identify it.
- Is head and shoulders pattern bullish or bearish?
- How to make profitable trades using this powerful price action setup.
- We'll cover the different types of head and shoulders patterns.
- The ideal entry, stop loss and take profit levels.
- And walk through real chart examples.
Trading isn't easy, and no indicator or chart pattern works 100% of the time but used properly, the head and shoulders top formation can tip the odds in your favor.
Whether you're a beginner looking to learn chart pattern trading or an experienced trader wanting to brush up on key patterns, this guide has everything you need to understand and trade head and shoulders like a pro.
Ready to boost your technical analysis game and spot potential reversals?
Let's dive in!
What Is the Head and Shoulders Pattern
In technical analysis, head and shoulders chart pattern are reliable reversal patterns that develop at the end of an uptrend and are identified by three peaks on a price chart - two smaller peaks (the "shoulders") flanking a larger peak (the "head"). The head and shoulders chart pattern indicates a potential trend reversal of the current uptrend.
Specifically, head and shoulders charting signal an impending bearish trend reversal after an uptrend, or a bullish trend reversal after a downtrend – in the case of the inverse head and shoulders. It is considered a warning sign that the tide is about to turn.
This pattern occurs across all timeframes and financial markets including stock, Forex, cryptocurrencies, etc.
To spot head and shoulders stock pattern, traders look for a few key characteristics:
- The "left shoulder" - price rises then falls, forming the first peak
- The "head" - price rises again to form a higher peak
- The "right shoulder" - price falls from the head, then rises again but not as high as the head
- The "neckline" - a support level connecting the lowest points of each trough
See the head and shoulders chart below:
When the price breaks the neckline, it confirms the pattern and indicates the trend is likely reversing. Mastering recognition of the head and shoulders pattern can clue you in on major potential trend changes.
Now that you know what is a head and shoulders pattern let’s see what the market psychology behind these chart patterns tells you.
What Does Head and Shoulders Pattern Tell You
Charting head and shoulders is more than just an abstract chart formation - it represents the psychology and emotions behind market reversals and how prices move. Understanding what drives the shoulders patterns can make it much easier to identify and trade.
The First Shoulder
The initial trend forms as optimism fuels continued buying which ultimately drives the price higher. The first shoulder marks a shift as a few market participants take profits or think the trend is overextended.
The Head
But the crowd regains its confidence and resumes the trend - forming the head.
At this point, however, uncertainty is creeping in. The rally leading to the head exhausts the remaining buyers and once the last bulls take their profit at the peak, the market starts running out of momentum.
The Second Shoulder
The right shoulder shows a last-ditch effort by stubborn bulls to resume the uptrend. But with buyers tapped out, any strength quickly fades giving birth to the head and shoulder stock pattern. When the neckline breaks, the jig is up - bears take control as panic sells accelerate the reversal.
Understanding this psychological tug-of-war helps traders recognize when the head and shoulders formation is forming. No one knows how long trends will last but by identifying when market sentiment shifts, chart patterns like this one offer clues about when reversals are imminent. This insight lets traders profit from both the initial trend and the forthcoming move in the opposite direction.
Head and Shoulders Pattern Formation Steps
There is a clear sequence of steps that occurs when the head and shoulders Forex pattern forms.
Let's walk through each one of the head and shoulders pattern rules:
Rule #1: Prior Trend
It all starts with an uptrend leading into the left shoulder, so before the pattern begins, we need to see an uptrend or prolonged move higher. This provides the baseline for the impending reversal.
Rule #2 Left Shoulder
The left shoulder forms first after the prior uptrend peaks. Price then declines and starts to form the first shoulder of the head and shoulders trading pattern.
Rule #3 Head
After the left shoulder, we enter the head which is the highest peak achieved throughout the pattern. Volume is often elevated on the left shoulder and head.
Rule #4 Right Shoulder
Next comes the right shoulder which mimics the left shoulder's peak but is slightly lower. We must form the right shoulder to complete the head and shoulders pattern rules. The left and right shoulders hit similar price levels or they peak around the same price range. From the right shoulder the price should start falling.
Rule #5 Neckline
The neckline connects the two shoulder lows or the two valleys in between the head and acts as major support. When broken, it signals the head and shoulders pattern breakout.
Rule #6 Volume
Volume on the head is higher than the shoulders which confirms the reversal. For head and shoulders stock prices, rising volume on the left and right shoulders shows distribution.
Rule #7 Neckline Breakout
Once the right shoulder is formed, we wait for the neckline breakout which is the make-or-break moment. When price closes below the neckline, we have confirmation that the head and shoulders technical analysis is valid and we can enter short positions.
Rule #8 Support Turned Resistance
Once broken, the neckline turns into resistance and prevents price from reclaiming the level.
Rule #9 Profit Target
After the head and shoulders pattern breakout, the next step is measuring the distance from the head to the neckline. This gives us our minimum price targets to aim for. Then we set our stop loss above the highs of the right shoulder and our profit target at the projected breakdown point.
So is the head and shoulders bullish or bearish?
See below the answer:
Is the Head and Shoulders Pattern Bullish or Bearish
The head and shoulders pattern Forex traders rely on is a bearish reversal indicator that marks a potential top in an uptrend. It signals that demand has dried up and the price is ready to fall.
While the standard formation is bearish, there is also a bullish version called an inverse head and shoulders pattern or the head and shoulders bottom formation.
See below what's the difference between the two?
Head and Shoulders Pattern vs. Inverted Head and Shoulders
The inverted head and shoulders pattern forms after a downtrend and signals a potential trend reversal to the upside. It contains the same elements as a standard chart head and shoulders but in an upside down formation.
Key differences:
- Standard head and shoulders is bearish, inverted is bullish
- Standard head and shoulders formation after an uptrend, inverted head and shoulder pattern forms after a downtrend
- Neckline is resistance in standard pattern, support in inverted
- Breakout direction is down for standard, up for inverted
The inverted head and shoulders pattern bullish traders watch for can mark bottoms in a downtrend. Other names for this pattern include head and shoulders bottom or upside down head and shoulders.
Other Head and Shoulders Types
Beyond the standard and inverted formations, there are a few other types of head and shoulder patterns technical analysts watch for.
Complex Head and Shoulders
This is a variation with multiple left and right shoulders that form at different price levels. It shows indecision but ultimately signals the same reversal.
Double Top Head and Shoulders
In this stock head and shoulders pattern, the head is flat like a double top formation rather than a sharp peak. In head and shoulders charting this is still a bearish reversal signal.
Horizontal Head and Shoulders
This formation occurs when the pattern develops along a horizontal support or resistance level rather than slopes.
Sloping Head and Shoulders
The neckline slopes up or down rather than being horizontal. The slope can indicate the strength of the forthcoming move.
Quasimodo Head and Shoulder
This is a crooked or distorted head shoulder pattern because the second valley forms way lower in comparison to the first valley.
While these variations exist, the standard and the bullish head and shoulders pattern remain the most popular and widely followed. Focus on nailing down these two patterns before moving to more advanced formations.
Advantages and Disadvantages of the Head and Shoulders Pattern
The head and shoulders chart pattern is not perfect, so here are some key pros and cons to consider:
Advantages
- Clear trading rules and entry/exit points
- Works on all timeframes and financial markets
- High profit potential if pattern confirms
- Stop loss contained below right shoulder
Disadvantages
- Subjective drawing of neckline
- The head and shoulders pattern stocks requires trend confirmation
- Complex head and shoulder chart reading can be misleading
- Pattern may fail to complete
How Reliable Is the Head and Shoulders Pattern
Overall, stocks head and shoulders have a decent accuracy rate, especially when confirming technical signals are present. Estimates put the pattern's success rate between 60% to 75%.
However, the head and shoulders pattern failure rate is also noteworthy. Common reasons for failed head and shoulders patterns include:
- Incorrect pattern identification
- Early entry before confirmation
- Loss of momentum after breakout
- Breakout false signal (whipsaw)
To boost the accuracy of your head and shoulders trading, be strict with pattern confirmation rules, wait for the neckline break, and measure the target projection. Use stop losses in case the failed head and shoulders pattern does not reach the projected low.
While failures occur, the head and shoulders remain one of the more objective and reliable chart patterns for signaling potential trend reversals.
Now let's examine real-world case studies.
Strategies for Trading Head and Shoulders Patterns
Head and shoulders trading requires clear strategies to profit from them. Here are some key approaches to how to trade the head and shoulders price formation:
- Enter on Breakout: Wait for the neckline to break decisively before entering the trade in the direction of the expected reversal which helps confirm the pattern is completing. The entry price is the breakout price. Place a stop loss above the right shoulder for short trades or below it for long trades.
- Trade the Pullback: After the initial breakout, look to enter on a pullback to the broken neckline. This gives you a better risk vs reward entry point. Target the distance from the head down to the neckline.
- Focus on Quality Setups: Clear head and shoulders stocks on daily or weekly charts give the highest probability trades. Look for healthy trending leading into the setup. Be selective rather than trading every pattern.
In conclusion, head and shoulders pattern trading also require leveraging key chart levels for your entries, stops, and targets for added confluence.
Now that you're a head and shoulders pattern expert, you can start applying these strategies immediately. If you don't already have a trading account, consider opening one with a leading broker like Pepperstone or eToro if you’re a US resident.