The Head and Shoulders pattern is one of the most famous technical analysis patterns, appearing often on the currency market. Despite being documented a long time ago on the stock market, this pattern has stood the test of time to become one of the easiest ways to spot a trend reversal.
The Head and Shoulders pattern starts with a consolidation area. During a bullish or bearish trend, the market stops and consolidates for a while. There is no indication that this is the left shoulder in a reversal pattern. Instead, many investors give in to the temptation of trading the left shoulder in the direction of the underlying trend. In fact, it is perfectly reasonable to do so, as the price forms continuation patterns during the left shoulder’s consolidation. Look for bullish or bearish flags, triangles of all kinds, and more, to appear in this part of the pattern.
Below is what an inverse Head and Shoulders pattern looks like in the currency market. The market falls, and it consolidates for a while (left shoulder) before breaking lower. However, the break lower is quickly retraced. The bear market rally is identified as the “head” of the pattern, and after its formation, investors start suspecting a possible Head and Shoulders pattern.
The brown line you see in the chart above is called the neckline. It shows the areas where the price consolidated, and when the price breaks beyond this neckline, investors expect a measured move to occur.
How to trade the Head and Shoulders pattern
The key is the neckline because the measured move is projected at the moment the price breaks beyond it. However, to find the right entry, investors use information from the left shoulder.
If the neckline is copied and projected from the lower part of the left shoulder, the resulting area acts as support and entry for a future long trade. As for the stop loss, the only place that makes sense is the lowest point during the head’s formation.
The black line you see on the chart above is the measured move. It measures the distance between the neckline and the candles in the head. As mentioned earlier, investors project the measured move from the neckline, having a target for the long trade.
This specific Head and Shoulders pattern results in a risk-reward ratio over 1:2, which is satisfactory by all money management standards. When other factors reinstate the reversal conditions, the Head and Shoulders pattern becomes even more powerful. In the case shown above, the market formed a triple bottom during the head’s price action. Investors also check for Japanese candlestick reversal patterns.
- The Head and Shoulders pattern is a powerful reversal pattern.
- Investors use information from the left shoulder to find the entry point on the right shoulder’s formation.
- A proper stop loss must be at the lowest/highest point in the Head and Shoulders pattern.
- Other reversal patterns forming during the head’s price action reinforce the pattern.