Belonging to classic technical analysis patterns, the head and shoulders is one of the oldest reversal patterns documented. It forms at the end of both bullish and bearish trends and works on all trading environments.
There’s plenty of information regarding the head and shoulders pattern, and we aim at explaining quickly the pattern and focusing on how to trade it. As you’re about to find out, trading it requires a thorough plan, due to the particular characteristics of the currency market.
What Makes a Head and Shoulders Pattern
When it forms at the bottom of a bearish trend, the pattern is called an “inverted” head and shoulders. However, it has the same elements and follows the same trading plan as if reversing a bullish trend.
The numbers on the chart above correspond to the head and shoulders pattern. From left to right, during a bearish trend, the market takes a pause and consolidates.
At this moment, nothing suggests that a reversal pattern forms, but yet this is the first element in the pattern. Called the left shoulder, it holds the key to drawing and trading the head and shoulders pattern.
The price action on the left shoulder, the time taken for the consolidation, as well as the price range, play a critical role in the head and shoulders’ interpretation.
After the consolidation ends, the price dips viciously, leaving the impression that the bearish trend will keep on going. Typically, this is a fake move and traps the last bears.
What follows is a quick reversal up to the consolidation area the market formed on the left shoulder. Called the “head” of the pattern, the move lower followed by the quick reversal is the first clue traders have that the head and shoulders pattern forms.
Number three on the chart above is the right shoulder. This is a consolidation area similar to the one on the left shoulder. Effectively, the market builds energy to break, and it needs some time to clear the level.
So now we have two shoulders (left and right) and a head, making the head and shoulders pattern. However, it would be incomplete if we don’t mention the measured move.
To find it, draw a trendline containing the price action on the two shoulders (the blue line on the chart above). Called the neckline, it plays a central role in trading the pattern.
Next, measure the distance from the neckline until the furthest candles in the head. Finally, use a ninety-degree angle with the neckline to draw the measured move and project the outcome from the neckline. That’s the measured move, and it only shows the minimum distance that the price must travel after the head and shoulders pattern. Basically, it confirms the pattern.
How to Trade the Head and Shoulders
Identifying the pattern is one thing, trading it is another. Here’s what to do:
- copy and paste the neckline from the bottom of the left shoulder
- measure the time it took the left shoulder to form and project it on the right shoulder
- when the price reaches the projected neckline on the right shoulder, go long with a stop-loss order at the lowest point in the head
- when the projected time on the right shoulder expires, the price should have already broken the neckline
- typically, the price retests the neckline, but that’s not a mandatory condition; if it does, it is a great entry place, with a stop-loss at the previous entry’s level
- finally, the third entry appears when the price exceeds the highs in the swing before the neckline’s retest
The measured move is not the take profit. For it, use a risk-reward ratio of minimum 1:2.
It means that the take-profit level considers a distance two times bigger than the one needed for the stop-loss.
The head and shoulders pattern is a wonderful one, offering clear trading setups on all markets and timeframes. The bigger the timeframe is, the more powerful the implications are.
Its drawdown is that it takes a lot of time to complete. Because it has two consolidation areas, traders must have a lot of patience when trading such patterns.
However, what matters is the accuracy of a trade and the trading discipline. While the head and shoulders pattern provides accurate trades, it is the trader’s job to execute them.