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Head and Shoulders Pattern in Forex Trading
By Stjepan Kalinic , Updated on: Apr 07 2023.
Head and shoulders is a chart pattern that signals a potential reversal on the forex market. It is one of the most popular patterns because of its simplicity, reliability, and transparent execution rules.
The 6th rule of Dow Theory states that trends persist until the reversal occurs. Thus, it is not surprising that fortunes were made and lost throughout the history of the markets by trying to predict the reversal.
Yet, among the reversal cues, head and shoulders is by far the most superior pattern since it clearly shows the break in the market structure when a lower high follows a higher high — signaling exhaustion of the trend.
What are forex chart patterns?
Forex chart patterns are graphical formations that appear on charts as the price action unwinds. They provide visual cues about the price movement, often with rather precise entry conditions, and take profit and stop-loss projections.
While there are many different patterns, we classify them as reversal patterns, continuation patterns, and bilateral chart patterns.
Reversal patterns are those that signal for a potential trend to reverse. Although head and shoulders is the most popular one, these can also include double tops and double bottoms.
On the other hand, continuation patterns signal that the trend will continue after a short consolidation. These include flags, rectangles, and pennants.
Finally, bilateral chart patterns can move either way, although they have slight statistical biases to either one side or the other. These include triangles (ascending, descending, or symmetrical) and wedges. Wedges are a special sort because they have a solid directional bias but not a trend bias – thus, they can be reversal or continuation patterns. For example, a falling wedge will generally be bullish, while a rising wedge will be bearish.
Understanding head and shoulders pattern
The Head and shoulder pattern appears when the price rallies but subsequently declines to support before rallying once again and establishing a new high. Yet, the price returns to the same base support, thus failing to establish a new higher low.
This process forms the 3 key components of the pattern: left shoulder, head, and neckline.
Now, it is time to observe the final part of the formation as price needs to rise once again but form a lower high, thus creating the right shoulder.
When it declines again, traders should sell the break of the neckline and put the stop-loss above the right shoulder. On the other hand, a target for taking profit should be the height of the formation itself — from the baseline to the top of the head, thus creating a risk-to-reward ratio that is better than 1:1.
Can it be inverted?
The Head and shoulders pattern works backward as well. In that case, it is called an inverse head and shoulders pattern.
This formation appears in the downtrends and looks the same, except that it is upside down. Now the neckline is not a support but a resistance. Meanwhile, the head is not a higher high, but instead, it is a lower low.
Other than that, it is traded exactly like the regular pattern with recommended stop loss below the right shoulder and a take profit target equal to the height of the formation.
How to trade head and shoulders patterns?
Regardless of the timeframe, head and shoulders is one of the patterns that take time to complete. Thus, it might take a while from the moment you spot the pattern until the moment you can trade it.
A rule of the thumb is to enter the trade upon the neckline break. While necklines are usually horizontal and therefore straightforward to draw, some formations might be tilted. In that case, incorrect drawing might be a deciding factor.
However, you might opt to enter on the pullback and not the initial break. You might get fewer valid opportunities but a higher success rate in the long term.
Once you are in the trade, you can project the height of the formation (neckline to the peak of the head) on the downside to get your take profit target. Meanwhile, the stop-loss will depend on the market structure above the neckline, but as a rule of thumb, it should not be smaller than 10% of the Average True Range (ATR).
Consider the following example:
Head and shoulders formation on EUR/GBP 15-min chart, Source: TradingView
Following a stronger period, EUR GBP eventually started showing some weakness after it established its left shoulder and head while returning to the 0.85300 neckline, which was strong support.
Notice how the volume picks up as we get through the right shoulder, basically peaking around the decisive breakout. Furthermore, notice how a pullback falls slightly short but still offers an opportunity for those late to get in.
Finally, the price descends to the projected take profit target, which is around 0.85070.
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Head and shoulders details to keep in mind
- There are 4 key components of the pattern: left shoulder, head, right shoulder, neckline
- If the right shoulder rises above the head at any point, the pattern is invalid
- Stop-loss should be above the right shoulder, or at least 10% of the Average True Range (ATR)
- Volume confirms the breakout — look for the volume to pick up as the pattern breaks
Conclusion
Head and shoulders is unquestionably one of the most popular chart patterns. It is simple, reliable but above all, it takes time to form — thus providing an opportunity to develop a clear plan of action. Furthermore, it gives clean rules and guidelines for take profit and stop-loss levels.
Although very popular, it is not perfect, and it can still fail at least 20% of the time. Therefore, one must adhere to sound risk management strategies before overcommitting resources to a single opportunity. The market will always be there tomorrow.
Frequently asked questions
How reliable is a head and shoulders pattern?
The Head and shoulders pattern is one of the most popular price action patterns for a reason. Statistically, it works about 83% of the time with a proper setup. A valid setup is classified by 2 swing highs with a third higher swing high in between them. Then, the price has to break through the base, also known as the neckline.
Can head and shoulders pattern fail?
The market can do anything at any time. Thus, any price action pattern can fail. Fortunately, the head and shoulders pattern is one of, if not the most reliable one. Yet, it still fails about 15-20% of the time. Thus, you have to use sound risk management techniques.
How do you invalidate head and shoulders?
By definition, the head and shoulders pattern should have 2 highs with a higher high in between them. If the price rises above the higher high before breaking the neckline — the pattern is invalidated, and it shouldn’t be traded upon the future break of the neckline.
