The head and shoulders pattern is arguably the most common chart pattern because it shows up on all time frames. Both swing and day traders can use this configuration and novice traders are particularly fond of it because it is easy to identify the pattern.
Understanding the Head and Shoulders Pattern
The head and shoulder is a reversal pattern that forms as a result of a decline in the price movement of an asset. The pattern has three distinctive valleys that form successively, one after the other. The second or middle valley, the head, is the deepest. The other two peaks are the shoulders; they are noticeably shallower and are often of the same thickness and height. Trade volume plays a significant role in how the head and shoulders form.
Parts of the Head and Shoulders Pattern
- Left shoulder: This part of the pattern is formed when the price of the underlying asset rises and consequently declines.
- Head: The middle valley, also known as the head is formed when the price picks up. A mountain-like peak characterizes the head.
- Right shoulder: This shoulder is formed immediately after the head as a result of a decline in the asset’s prices. This decline is then followed by a rise in prices, which is shallower than the head.
Using the head and shoulder pattern to trade
To effectively trade with the head and shoulder, it is important to become familiar with the neckline. The neckline is the average price point between the low that comes after the left shoulder and the low that comes after the head.
When using this pattern, what you are really looking for is for the price to go lower than the neckline - i.e. after the high point of the right shoulder. It is important that you wait for the pattern to completely form before trading with it. Before executing a trade, it is recommendable that you note down potential changes to your profit targets. Most traders execute a trade when the neckline no longer follows a linear pattern, that is, during a breakout.
The difference between the head price points and the shoulders’ low price point is the profit target. To obtain a profit target for a downside trend, you simply subtract the difference between the head price points and the shoulders’ low price point from the neckline obtained above.
The role of volume in pattern formation
As mentioned earlier, volume plays a critical role in how the head and shoulders are formed. High trade volume follows a high price as illustrated by the left shoulder. On the contrary, the head is formed when the volume declines; this is typically an indication that buyers are less bearish. On the right shoulder, the volume picks up slightly more than on the head. When the market reaches a linear neckline, the market is said to have broken.
Like all other patterns, the head and shoulder is not precise and is prone to marginal errors. However, this pattern is easy to use to formulate a trading strategy due to the rational movement of asset prices.
Reverse Head and Shoulders Pattern
There are two types of head and shoulders patterns: normal and reverse (or inverse). The normal one is by far the most popular and easy to recognize. It is formed by a head that is higher than the two shoulders, and a neck-line that presents the level of support.
Unlike the normal version, an inverse head and shoulders trend requires more expertise and experience. The inverse head and shoulder pattern is the exact opposite of the normal one – it has a head that is lower than the shoulders, and the neckline represents the level of resistance.