Head and Shoulders Pattern

What Is 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 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. Using the pattern, traders can adjust risk levels and set profit targetsProfit TargetsThe estimated amount of profit that management intends to achieve during an accounting period is called target profit, and it is forecasted and revised on a regular basis as the business progresses.read more when trading forex or stocks.

Key Takeaways
  • The head and shoulders pattern is a common pattern formed in stock charts and forex pair charts, signaling that a reverse of price is underway.
  • The head and shoulders trading pattern means bulls having lost conviction, and bears 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).

How Head And Shoulders Trading Work?

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Source: Head and Shoulders Pattern (wallstreetmojo.com)

The head and shoulders pattern is a helpful chart pattern that traders can identify through technical analysis or reviewing current trends in the financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more. 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 to around the previous pullback (forming the head)
  5. One last uptrend that does not rise as high as the previous “top”
  6. The final pullback often resulting in lower lows (forming the right shoulder)
Graph 1

Source

Head and shoulder patterns form and create the look of a person’s head and shoulders that traders can identify through 3 tops, with the middle (the head) being the highest peak. These formations will typically occur when buying conviction begins to slow down. And sellers start to liquidate or sell out their positions.

Traders will often look at head and shoulder formations as a bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more setup due to the high amount of selling 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 is generally signaling that the asset is under selling pressure.

#1 – Head And Shoulders In Stocks Trading

It is critical to consider the volume being 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) will typically take the stock to lower prices.

#2 – Head And Shoulders In Forex Trading

Not only can traders 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.

Graph 1-1

Source

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

Head And Shoulder Pattern Rules

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

Head And Shoulder Pattern Failures

Many people look at a head and shoulder pattern chart as a reliable indicator. With that said, it is not a perfect signal and can sometimes be misinterpreted. Here are a few common failures:

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.

Frequently Asked Questions (FAQs)

Is Head And Shoulders Pattern Bullish?

The H&S pattern is a bearish setup. However, an inverse H&S pattern can be viewed as bullish. Also, it will often send false signals, failing to complete the pattern and continue in a bullish manner.

What Is Head And Shoulder Pattern Breakout?

A breakout is when an asset rapidly starts a new trend and continues it aggressively. Breakouts occur with H&S patterns when the asset’s closing price closes below the previous low (also called the neckline).

What Is Double Head And Shoulder Pattern?

A double head and shoulder occur when one H&S pattern forms on a chart right after another one. Double H&S patterns will often indicate the asset is in a consolidating phase of the investment has not changed the direction yet. As the second H&S pattern comes to completion, it will often be decided in which direction it will continue by a closing price either below the previous low (neckline) or above the previous high price (the head).

This has been a guide to What is Head and Shoulders Pattern. Here we discuss how does it work, rules, along with head and shoulders in forex trading. You may also have a look at the following articles to learn more –

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