How to Trade the Head and Shoulders Pattern

The head and shoulders chart pattern is a popular and easy to spot pattern in technical analysis. It shows a baseline with three peaks with the middle peak being the highest. The head and shoulders chart pattern depicts a bullish-to-bearish trend reversal and it indicates that an uptrend is nearing its end.

The pattern appears on all time frames so it can be used by all types of traders and investors. Entry levels, stop levels and price targets make the formation easy to implement because the chart pattern provides important and easily visible levels.

What the head and shoulders pattern looks like

Formation of the pattern seen at market tops:

Left shoulder: Price rise followed by a price peak, followed by a fall Head: Price rises again to form a higher peak Right shoulder: A fall occurs again, followed by a rise to form the right peak lower than the head

Formations are rarely perfect. There may be some noise between the respective shoulders and head.

Inverted head and shoulders pattern

Formation of the inverse head and shoulders pattern seen at market bottoms:

Left shoulder: Price falls followed by a price bottom, followed by an increase.

Again, there may be some market noise between the respective shoulders and head.

Place the neckline

The neckline is the level of support or resistance that traders use to determine strategic areas to place orders. The first step in placing the neckline is to locate the left shoulder, head and right shoulder on the chart.

We connect the layers to the left shoulder with the layers created to the head in the standard head and shoulders pattern (market top). This creates our neckline, the dark blue line on the charts.

We connect the high to the left shoulder with the high formed to the head in a reverse head and shoulders pattern. This creates our neckline for this pattern.

How to trade the pattern

Traders must wait for the pattern to complete because a pattern does not develop at all or a partially developed pattern may not complete in the future. Partial or almost completed patterns should be watched, but no trades should be made until the pattern breaks the neckline.

We are waiting for price action to move below the neckline to the peak of the right shoulder in the head and shoulders pattern. We wait for price movement above the neckline after the right shoulder is formed for the inverse head and shoulders pattern.

A trade can be started when the pattern is completed. Plan the trade, write down the entry, stop and profit targets, as well as note any variables that will change your stop or profit target. The most common entry point is when a breakout occurs: The neckline is broken and a trade is taken.

Another entry point requires more patience and comes with the possibility of missing the move entirely. This method involves waiting for a pullback to the neckline after a breakout has already occurred. It is more conservative because the trade can be missed if the price continues to move in the direction of the breakout and we can see if the pullback stops and resumes the original breakout direction.

Place your stop

The stops are placed just above the right shoulder or top layer pattern after the neckline is penetrated into the traditional market top pattern or the head of the pattern can be used as a stop. However, this is probably a much higher risk, and it reduces the reward-to-risk ratio of the pattern.

The stop is placed just below the right shoulder in the reverse pattern. Again, the stop can be placed at the head of the pattern, but this exposes the trader to greater risk. The stop will be placed at $104 just below the right shoulder in the above chart after the trade is taken.

Set your profit goals

The profit target for the pattern is the price difference between the head and the low of any shoulder. This difference is then subtracted from the neckline breakout level at a market top to provide a price target for the downside. The difference is added to the neckline breakout price to provide a price target to the upside for a market bottom.

An example of the profit objective for the reversed head and shoulders pattern would be:

$113.20 as the high to the left shoulder – $101.13 as the low of the head = $12.07

This difference is then added to the breakout price which is subtracted in the case of a regular head and shoulders pattern. The breakout price is around $113.25, giving us a profit target of $125.32 ($113.25 + $12.07).

Why the head and shoulders pattern works

No pattern is perfect and they don’t work every time, but the chart pattern works in theory for several reasons. We will use the market top will for this reasoning, but it applies to both:

Sellers have started to enter the market and there is less aggressive buying as prices from the market top or head down. Many people who bought higher in the last wave or bought on the rally in the right shoulder are now being proven wrong and face huge losses as the neckline is approached. This large group will now exit positions, driving the price towards the profit target. The stop above the right shoulder is logical because the trend has shifted downward. The right shoulder is a lower height than the head. So the right shoulder is unlikely to be broken until an uptrend resumes. The profit target assumes that those who are wrong or bought the security at a bad time will be forced to exit their positions. This will create a reversal of similar magnitude to the topping pattern that just occurred. The neckline is the point at which many traders experience pain and will be forced to exit positions. This pushes the price towards the price target. Volume can also be viewed. Preferably, we want the volume to expand as a breakout occurs during inverse head and shoulders patterns or market bottoms. This shows increased buying interest which will move the price towards the target. Declining volume shows a lack of interest in the upward move and warrants some skepticism.

The pitfalls of trading head and shoulders

You may encounter some potential problems trading a head and shoulders pattern:

You need to find patterns and watch them develop, but you should not trade this strategy until the pattern is complete. This can mean a long period of waiting. It won’t work all the time. The stop levels will sometimes be hit. The profit target will not always be met, so traders may want to fine-tune how market variables will affect their exit from the security. The pattern is not always tradable. The calculated price targets are unlikely to be met if there is a massive drop on one of the shoulders due to an unpredictable event. Patterns can be subjective. One trader may see a shoulder when another does not. Define in advance what a pattern is for you.

The Bottom Line

Head and shoulder patterns occur in all time frames and can be seen visually. They are sometimes subjective, but the complete pattern provides entries, stops and profit targets, making it easy to implement a trading strategy.

The pattern is composed of a left shoulder, a head, then a right shoulder. The most common entry point is a breakout of the neckline with a stop above (market above) or below (market below) the right shoulder. The profit target is the difference between the high and low with the pattern added (market bottom) or subtracted (market top) from the breakout price.

The system is not perfect, but it provides a method to trade the markets based on logical price movements.

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