One of the most well-known patterns in technical analysis is called the “head and shoulders” formation. This pattern indicates a market reversal and is one of the most reliable signals in technical trading. At the same time, the pattern is easy to understand, even for beginners.
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Already in the classic book “Technical Analysis of Stock Trends” from 1948, the Head and Shoulders formation is referred to as “one of the most common patterns – and at the same time one of the most reliable,” and this definition still holds, despite the modern market noise, algorithmic chaos, and high-frequency trading.
A head and shoulders is a reversal pattern, and it can occur at both the top and the bottom of a trend reversal. Therefore, the pattern can be called either a “head and shoulders top” or a “head and shoulders bottom.”
A classic top formation (Fig.1) consists of two peaks at almost the same level, forming the shoulders. Between them is a slightly higher peak, known as the head. The bottoms of the formation are called the “neckline,” and this must be breached before the pattern is complete. Once the neckline is broken, the trader hopes that the market will pull back a distance at least equal to the distance from the head to the neckline. (H) in Figure 1.
When the trader draws the neckline, they should look for the two lows formed by the shoulders. It’s the break of this line that completes the formation and simultaneously initiates a potential trade.
The head and shoulders pattern is found on all timeframes, from a few minutes up to weekly and monthly charts. However, the higher the timeframe, the more reliable the pattern typically is. If you’re trading on a platform that also indicates market volume, you will usually see an increase in volume when the price breaks through the neckline. The higher the volume around the break, the more valid the pattern is.
Unfortunately, one cannot expect the market to always form a perfectly defined head and shoulders pattern. Often, for example, the neckline may be slanted, or the two shoulders may not reach exactly the same height. However, this does not necessarily mean that the signal is less valid. Therefore, it can be worthwhile to practice identifying formations that are not entirely classic. In the following, we will show examples of variants of the head and shoulders pattern. To find them, it’s easiest to look for a peak, along with two smaller peaks – then you can draw the neckline. Conversely, of course, if it’s a bottom formation.
Figure 2 shows an H-S-H (Head-Shoulders-Head) pattern in the currency cross of the euro against the pound on an hourly chart. This is a version of the pattern with a wide left shoulder.
Figure 3 shows an H-S-H (Head-Shoulders-Head) pattern in the DAX on a daily chart. Here, there is a very slanted neckline, which still provides a valid signal.
Figure 4 shows an H-S-H (Head-Shoulders-Head) signal in the Danish ISS stock on a daily chart. Here too, there is a slanted neckline, and the right shoulder has a “double top”. However, a relatively large drop is observed again when the neckline is breached.
Figure 5 shows the currency cross of Australian dollars against US dollars with an H-S-H bottom formation. The bottom formation is characterized by the same patterns as the top formation, just in reverse.
Figure 6 shows oil on a weekly chart. Here, there is an almost perfect H-S-H bottom.
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The trading strategy is simple: In a completed top formation, you’ll want to go short when the neckline is breached. If the break is followed by high volume, the bold trader will typically try higher leverage. The minimum target corresponds to the distance between the head and the neckline. Stops are usually set just above the right shoulder if it offers a reasonable risk/reward ratio. Ideally better than 1:3. In the time just after the break of the neckline, a minor retracement back towards the neckline can occur. Here, the neckline will typically act as resistance. Traders with a low-risk appetite may wait to enter the trade until this retracement is complete and have confirmed that the neckline indeed acts as resistance. For everyone else, it’s just a matter of patience if the price undergoes this classic retracement.
The battle between sellers and buyers: To understand the psychology behind the head and shoulders pattern, one can imagine that buyers are filled with enthusiasm during an uptrend, eagerly purchasing shares. Suddenly, however, some speculators begin to doubt the continuation of the trend and start to sell off. This creates the left shoulder. After a brief period of selling, enthusiasm picks up again, and buyers resume their purchases in the hope that the original trend is still in place. When the price reaches well above the left shoulder, more panic sets in. Was the correction/left shoulder an indication that the stock isn’t as strong after all? Doubt initiates another round of selling, thereby creating the head. The sell-off continues until we hit the neckline again, where buyers from the previous correction/left shoulder still linger. Buyers manage to push the price up to the same level as the first shoulder, where the stock price once again encounters a group of sellers from the time the top of the left shoulder was formed. The stock then plummets, and when the price breaks the neckline, it truly ignites fear. A few brave traders might attempt to buy up, but the price never surpasses the neckline again. Fear takes over, leading to a steady decline in price. The pattern is complete, and the uptrend has now turned to a downtrend.