Trading the Head and Shoulders Pattern

 

Hello there. This is tradingpedia.com and this video deals with the head and shoulders pattern, a reversal pattern that forms at the end of bullish trends. The opposite of the head and shoulders pattern is called the inversed head and shoulders pattern and forms at the end of bearish trends.

What is the Head And Shoulders Pattern

The head and shoulders is a classic reversal pattern, or a Western reversal pattern, because it was discovered for the first time in the United States and still shows hesitation at higher levels, during bullish trends.

It has the following components. The market is in a rising trend, and all of a sudden it begins consolidating, a triangle, pennant, flag, etc. It builds energy to break higher and at one point the breakout comes towards the highest point in the head and shoulders. Nothing suggests that a reversal pattern forms. However, shortly after the market reverses sharply towards the same level of consolidation. At that place, another consolidation starts before the price breaks lower. This is the pattern and you may see that this is called the left shoulder, this one here is the right shoulder, so you know the name for the pattern, and the head represents the price action we see at the top of the pattern.

How to Trade the Head and Shoulders Pattern

The pattern resembles the human body, and to trade it there are some steps to follow. There is one such thing called the neckline. This is a line that contains the price action on the two shoulders. Price stays here on the neckline before moving lower.

The pattern also has a measured move that equals the empty space from the candlesticks to the neckline, but make sure you have a 90 degree angle on the neckline. This is the minimum distance that the market follows. Also, conservative traders book profits by the time the market reaches 75% of the measured move and put the stop loss to breakeven and trailing it as the market moves forward.

This is the theoretical concept. In reality, head and shoulders patterns are really ugly, especially on the currency market. Because the currency market reacts promptly to news, economic reports, etc., the patterns take various forms. For instance, this is the hourly EURJPY, and it June it formed a head and shoulders pattern.

The market was in a rising trend, formed a consolidation on the left shoulder, then it broke higher and quickly retraced towards the same level where the consolidation continued. This would be the right shoulder and for the neckline we connect the price action on the two shoulders, ideally you should connect only the real bodies and avoid the shadows. As you can see, this is already an ugly head and shoulders pattern – it does not look like in textbooks. For the measured move we measure the price action from the candlestick in the top of the head and then we use a 90 degree angle on the neckline. Finally, we project it from the breakout point.

The market broke the neckline and retests it, as it often happens. A conservative approach requires booking half profits at 75%, moving the stops to breakeven, and trailing the stop for the half position that remained open.

This might be a head and shoulders pattern as well. We see that the market moved higher, consolidated, spiked higher and came back to another consolidation area. We can easily do the same thing on the same currency pair with this being the left shoulder, this the right shoulder, the neckline looks something like this, and then when the market breaks lower, the measured move would be this one from here to here – the minimum distance that the market should have traveled. Did it travel it or not?

The Bottom Line

The price broke the neckline, it retested it two times and then went to the 75% of the distance mentioned earlier. So, conservative traders booked half the profits there, and the market retraced to the stop for the other half. Booking half on the conservative approach was the good decision, as sometimes these patterns do not work.

As a rule of thumb, the bigger the timeframe the pattern appears on, the less likely that the price will reach the full measured move because the pattern becomes obvious for all market participants. Thank you for being here, bye bye.