After the triangles patterns (Symmetrical, Ascending, Descending), head and shoulders pattern is almost the most famous and popular chart pattern known by the Forex and stock traders.
What Is a Head and Shoulders Pattern?
A typical “Head and Shoulders” is a kind of chart pattern that consists of three highs. The middle one is usually higher than the right and and the left one. This pattern works as a reversal pattern, if the price succeeds to break below the pattern’s support line which is called neckline.
Sometimes the Triangle and Head and Shoulders patterns, are combined with each other. It means you can see a head and shoulders formed inside a triangle. The reason is that the nature of both of these patterns is the same:
They form when the market is slowed down to make a new decision to keep on following the same direction, or, to reverse and change the direction.
Both of these decisions, keeping on moving toward the same direction (which is known as continuation), and changing the direction (which is known as reversing or reversal), are very important for traders, because they are both good opportunities to take some profitable positions.
Triangles are mainly continuation patterns, whereas head and shoulders is usually a reversal pattern. However, I have seen so many cases that markets continued the trend after a head and shoulders pattern.
Something that helps you to stay away from making mistakes is that you enter the markets only when there is a breakout, not when you just see a pattern. It means you should not take a long position, if you see a head and shoulders formed at the bottom of a downtrend, because although head and shoulders is known as a reversal pattern, it is still possible that the downtrend to be continued after the formed head and shoulders. It is the same if you see this pattern at the top of an uptrend. You shouldn’t go short just because you have located a pattern.
Let’s see how the head and shoulders pattern looks like. Then we will focus on entering the markets after forming a head and shoulders pattern on the chart.
The most typical form of the head and shoulders pattern is the one that forms at the top of an uptrend. This type of head and shoulders really looks like a head and two shoulders at left and right.
The below screenshot shows two head and shoulders patterns formed at the top of an uptrend. The first one formed at left (the bigger one), and the second one formed after that (the smaller one). The head and shoulders patterns that form at the top of the uptrends and are called “Head and Shoulders Top” by some traders have a support line which is called neckline:
The below screenshot shows another head and shoulders pattern that formed right after the above ones. However, this pattern is not a typical head and shoulders, because the first shoulder is formed higher than the head, whereas it has to be lower. Therefore, we cannot call it “head and shoulders”. This pattern has a different name and is called “Triple Top”:
This is another example of an atypical head and shoulders that is called Triple Top:
As you see these patterns sometimes combine with each other, and so, it will be hard to say what pattern is formed. However, we really do not have to name patterns. Naming patterns is not that important. Something which is very important is that we know what is going on in the markets, and how to enter the markets to make some money. We will talk about this matter in details later in this article.
Now, let’s take a look at the head and shoulders that form at the bottom of downtrends. These kinds of head and shoulder patterns look inverted, and the neckline that was used to be a support line with the uptrend head and shoulders is a resistance line with the downtrend head and shoulders (although we still call it neckline). That is why these kinds of head and shoulders are called “Inverted Head and Shoulders”. They are also called “Head and Shoulders Bottom” by some traders:
Atypical head and shoulders that form at the bottom of downtrends are called “Triple Bottom”.
How to Trade Head and Shoulders Pattern
I think I have already showed you enough number of examples and now you know what head and shoulders, triple tops and triple bottoms are. Now the question is: how can we use these patterns to take some positions and make money?
If you already had the chance to read the articles I have written about the other chart patterns like triangles and rectangles, you know that I always recommend you to wait for a support or resistance breakout, no matter what kinds of pattern is formed on the chart. For example, if there is a continuation pattern like Symmetrical Triangle formed at the top of an uptrend, although it is more possible that the price keeps on going up and the trend to be continued, you’d better to wait for the market to show you that it wants to keep on going up before you go long. And this can be done by breaking above the triangle resistance. Even when the price continues the trend and you go long to follow it, you have to set a proper stop loss because you never know when it will reverse. Sometimes, the market suddenly reverses after a small continuation movement that formed after forming a continuation pattern.
The same rule has to be applied to all the other chart patterns, including head and shoulders. It means, if you see a head and shoulders formed at the top of an uptrend, just wait for the market either to break below the neckline to go short, or above the resistance line (if any) to go long.
Now, I am showing you some examples and tell you how you can trade the chart patterns like head and shoulders. You will see that trading the head and shoulders is exactly the same as triangles. At the beginning of this article, I told you that usually the head and shoulders (and also triple tops or bottoms) are formed inside the triangles. Now you can see what I meant:
The above screenshot shows the triple top you saw on this article before. As you see the triple top is formed inside a symmetrical triangle. Later on, the support line which is the triple top neckline or the triangle lower leg, was broken and the price went down. You could go short as soon as the first candlestick closed below the support line. The stop loss could be placed several pips above the candlestick that closed below the support line.
This is another example (below). I am showing the triangle again, because I want to emphasize that in most cases, the triangle and head and shoulders are with each other and you can trade them with the same rule. Here, you should wait for the first candlestick to close below the support line to go short. Your stop loss has to be placed above the candlestick which has broken below the support line:
The below screenshot shows an “Inverted Head and Shoulders”. The entry is based on the same rules and is done after the neckline breakout which is a resistance in this case. In the below example, because the candlestick which has broken above the resistance is relatively long, I prefer to place the stop loss around the open price of the candlestick and not below it. I do this because I do not want to make the stop loss too wide:
What About the Target Order Size?
Nobody knows how far the market will go after forming a trade setup. All we can do is that we locate the trade setup, take the position, set the stop loss and target orders and wait.
Like what we learned when discussing about the Symmetrical Triangles, there are some analysis and techniques that enable you to determine the size of the market movement after forming of a head and shoulders. You can refer to the symmetrical triangles article and learn it. The same techniques can be applied to the head and shoulders trade setups too because as you saw this pattern is in fact a special form of the symmetrical triangle patterns. I do not want to repeat them here in this article. On the other hand, these techniques are not exact and precise in many cases. Therefore, I recommend you not to make your trading too complicated by applying these techniques. You should always keep your trading as simple as possible.
Regarding choosing the target order size for the positions you take based on the head and shoulders breakouts, I recommend you not to take positions with less than a 1:3 risk/reward ratio. It means your target has to be x3 larger than the stop loss. An optimum and on time entry helps you have a tight stop loss, so that your target can also be tight and be reached by the market faster and easier. If you miss a trade setup and it looks too late to enter, you’e better not to enter and wait for another trade setup because if you enter, you can’t have an optimum and tight enough stop loss, and so, your target has to be too wide too.
The other thing is that a good trader is someone who is able to stay away from losing as much as possible. If you can manage to limit your losses, you can make money too. One way is that you move your stop loss when the market moves toward the target for a reasonable number of pips. For example, when your target is x3 of your stop loss, you’d better to move your stop loss to breakeven when the price has moved accordingly for x1 of the stop loss size. It helps you not to lose any money if the market goes against you before it hits the target.
There will be cases that the market hits your stop loss before you get any chance to move it to breakeven. This is something that happens for all traders. It is part of the game and it should not affect your trading. You can easily recover the loss in the next positions you take.