Head and Shoulders Pattern

The head and shoulders (H&S) pattern is one of the most widely used chart patterns by traders in the stocks and forex markets. Traders can identify the pattern from the three tops that form, with the middle indicating the highest price trend and the end of an uptrend.

It is an excellent technical indicator of a market trend reversal from bullish to bearish and can be used by novice and experienced traders and investors alike. One can rely on the head and shoulders pattern when speculating or predicting a change in the current price trend. In addition, traders can adjust risk levels and set profit targets when trading forex or stocks using the pattern.

• The head and shoulders pattern is common in stock charts and forex pair charts, signaling that a reverse of price is underway.
• The head and shoulders trading pattern means bulls have lost conviction, and bears are gaining control over the price. In other words, there are more sellers than buyers, and a price reversal is imminent (bearish reversal).
• It is not recommended to trade the H&S pattern until it is complete and the price has closed either below the previous low price or above the previous high.
• An inverse head and shoulders pattern like gold prices in mid-2019 forms when a downtrend nears completion and sellers regain control of the price (bullish reversal).

The head and shoulders pattern is a helpful chart pattern that traders can identify through technical analysis or reviewing current trends in the financial markets. Six critical steps characterize the chart pattern, including:

1. An established uptrend
2. A pullback (forming the left shoulder)
3. An uptrend that climbs higher than the previous peak
4. A retreat that draws around the previous pullback (forming the head)
5. One last uptrend does not rise as high as the previous “top.”
6. The final pullback often results in lower lows (forming the right shoulder)

The most frequent entry point for investors in head and shoulders pattern trading is at the breakout point or at the neckline. The calculation of the profit is done by subtracting the high and low points of the movement of the stock in the open market.

Traders may look at the following Hindustan Petroleum price chart to understand this pattern.

Source

As one can observe, the pattern resembles a person’s head and shoulders. Traders can identify it because of the 3 tops. Note that the middle peak, or the head is the highest among the three. These formations will typically occur after an uptrend in price. For example, in the above chart, we can observe that the pattern’s formation takes place after the buying conviction begins to slow down and bears start exerting selling pressure.

Traders will often look at head and shoulder formations as a bearish setup due to the high swelling that occurs on pullbacks. When the price or value of the asset fails to reach previous highs, like when the right shoulder is formed, it generally signals that the asset is under selling pressure.

The chart shows that the price dropped below the neckline, which is a sign for traders to enter short positions to benefit from the potential downtrend.

That said, one must remember not to use only this pattern for trading. Experts recommend using multiple indicators or candlestick patterns in addition to this pattern to increase the chances of achieving success.

For more such head and shoulder charts, one can go to the official website of TradingView.

#1 - In Stocks Trading

It is critical to consider the volume traded during the head and shoulders formation in stock trading. If the volume is higher when the stock is pulling back, it indicates that the stock is under selling pressure and that bulls (investors believing the asset will increase in value) have failed to take the price any higher for the time being. When this occurs, bears (individuals thinking the investment will decrease in value) typically take the stock at lower prices.

#2 - In Forex Trading

Traders can use the pattern while speculating on stock prices, but they can also use it for forex trading. The setup looks precisely the same as it would with stocks, characterized by its three tops, but instead of showing prices of stocks rising and falling, it involves currency pairs.

Source

When such a pattern forms on a currency pair chart, it also signals that a reversal in price may be imminent.

Although the pattern is likely the most recognizable chart pattern for technical analysis, there are a few rules to follow before entering into head and shoulders pattern trading.

• The volume must be higher during pullbacks than it is during rallies
• Please wait until the pattern is complete to ensure it is not a false signal.
• Enter a trade when the price goes below the first pullback point and closes below it. It then signals that the chart pattern is complete, and a bearish setup is underway.
• Always be ready for the possibility that the trade can reverse and go unfavorable. Some traders find it helpful to use a stop-loss when trading head and shoulder patterns to avoid losses.
• Know your risk levels and how much money you are willing to lose before entering the trade.

Many people look at a head and shoulder pattern stocks as a viable choice to make profitable decisions. With that said, it is not a perfect signal and can sometimes be misinterpreted. A few common failures of this technical analysis tool are as discussed below.

If the previous low (neckline) is not broken

When the asset fails to break the previous low (neckline) price, it can mean that the asset’s price is heading higher, and the pattern has failed.

If the volume is higher during rallies

When the volume is higher during rallies than during the pullbacks, it could signify a false H&S pattern. And the price will often continue in the uptrend.

This has been a guide to What is Head and Shoulders Pattern. Here we explain how it works, and how to interpret charts, rules, and failures. You may also have a look at the following articles to learn more –

• Equal Weighted Index
• Fundamental Analysis vs Technical Analysis
• Basis Trading