Chart Pattern Analysis: The Head and Shoulders Chart Pattern
Behind any price action pattern, there is a strong psychological reason that makes it work. A price pattern simply allows us to see in a visual manner the interaction between the supply side and the demand side of the market. In this regard, the Head and Shoulders Chart Pattern is no different than the other price patterns.
Now, the Head and Shoulders Chart pattern is a reversal technical pattern that signals the end of a bullish trend and the beginning of a new bearish trend. It’s no surprise that the Head and Shoulders chart pattern is such a popular pattern among all professional traders and the reason is that it survived the test of time.
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Head and Shoulders Chart Pattern Explained
The standard Head and Shoulders Chart Pattern is quite easy to spot because it consists of four major parts:
- The left shoulder is a simple swing high from where the market had a minor reaction lower.
- The head, which is the highest point of the H&S pattern. Normally the head is another higher high in the overall price structure of how the market moves.
- The right shoulder, which ideally should fall below the head and right in the vicinity of the left shoulder. Normally the right shoulder is another lower high in the overall price structure.
- The neckline is obtained by simply connecting the swing low prices between the left shoulder and the right shoulder.
When traded correctly the Head and Shoulders can be quite reliable pattern in detecting reversal points in the market. When the Head and Shoulder neckline is broken basically it means a break in the price structure, thus a shift in the market sentiment. This is valuable information that shows sellers stepping into the market so this is a reliable as it can get.
Of course the very first question we should ask ourselves is how we can enter this pattern. There are actually a few different ways to do that and next we’re going through some different examples to show you how it’s done.
Head and Shoulders Chart Pattern Example and Entry Methods
The standard entry of the Head and Shoulder pattern is at the break of the neckline. Obviously, we first need to draw the horizontal line between the left shoulder and the right shoulder. In figure below we have the 4h USD/JPY head and Shoulder pattern and the proper way to enter using this neckline breakout technique:
Another type of entry would be at the close of the breakout candle. This is a more conservative way of trading that seeks to avoid the possible false breakouts. Of course, the disadvantaged with this second entry technique is that you’ll need to sacrifice a small portion of your potential profits for a little bit of more comfort.
The third entry method is to enter at the right shoulder. At this point we’re using the left shoulder price structure and enter the market at that level. We basically trade in anticipation of a Head and shoulder developing because at this point we’re not even sure the market will develop this reversal pattern. In the chart below, we have the daily EURUSD chart and a short trading opportunity is presented by using the left shoulder technique:
This entry method requires a little bit of faith but the main advantage is that the potential profit is big enough to give us an incentive to at least try and execute our trades this way. You can get very creative as there are lots of variations you can trade the Head and Shoulder pattern and ultimately it all comes down to experience.
Inverse Head and Shoulder Pattern
The same Head and Shoulder pattern can appear at the end of a bearish trend as well and in this instance the pattern is called the inverse Head and Shoulder pattern. The name of the pattern is quite revealing because the price structure is similar to the normal Head and Shoulder pattern but turned upside down by 90 degrees.
How to Set Stop Loss and Take Profit Target When Trading with the Head and Shoulders Chart Pattern?
There are a couple of different options on how you can hide your protective stop loss using the Head and Shoulder pattern. The first option you can use the highest left-right shoulder price and place your stop loss just above that price.
Of course, this comes with drawbacks as the market can retest the head price again before moving in the desired direction. However, the plus side is that it minimizes the potential loss.
The traditional target for the Head and Shoulder pattern is measure the distance in price from the head down to the neckline and then project the same distance to the downside.
The Head and Shoulder has proven itself to be a great reversal pattern and a reliable way to make money trading. You can basically trade the head and shoulder pattern on all time frames, but obviously the bigger TF can produce bigger profits. The good news is that there are many different ways to trade this reversal pattern so you can experiment and find the best method that fits your needs.