How to Trade With The Head and Shoulders Pattern
The Head and Shoulders pattern helps identify market reversals and enables traders to time their trade entries better. It provides ideal buying and selling signals when an ongoing trend approaches its end. In this article, we discuss the Head and Shoulders pattern, and its top strategies.
What is the Head and Shoulders pattern?
The Head and Shoulders pattern is a trend reversal indicator that predicts bullish to bearish and bearish to bullish reversals in the forex market. The pattern signals the ideal points to either long a trade or short it. It consists of three peaks, where the currency pair price reaches a high point, stoops back to the last price move's baseline, rises over and above the first peak and again falls to the original baseline. At last, the currency pair prices rise for one last time, equal to the initial peak before it falls again to the base, confirming the downtrend.
- The left shoulder is the first peak in the currency pair prices
- The head is the middle peak which is the largest amongst all the three price peaks
- The right shoulder is the third peak that confirms the declining trend
For example, suppose you trade the USD/EUR currency pair at 2. The prices slowly increase and reach a peak price of 4.2 (left shoulder) before falling again to 3 (the intimal baseline). You hold onto the trade as prices slowly start increasing again and make a new high of 6.5 (head) but fall once more to 2.7. After this point, the currency pair prices increase for one last time and reach 6 (right shoulder), indicating a potential downtrend and signalling traders to exit the market. Thereafter, the USD/EUR currency pair prices decrease further and drop below the original trading price of 2.
Identifying the Head and Shoulders pattern
The Head and Shoulders pattern is identified by recognising three different peaks in the currency pair price charts on the same trading day. You look for a left shoulder peak which is formed when more traders enter the market and push the currency pair's price further by buying more of it and stocking it up out of sheer enthusiasm. The head peak, which is the highest price high in the chart, is then formed when traders are still enthusiastic about trading the currency pair, and wish to buy more of it with an expectation of a price increase, for a temporary period of time. This is followed by a price decline, as the enthusiasm narrows, near the currency pair's previous price low. The right shoulder is formed at last, which is due to the traders buying the currency pair for one last time, but because the prices fail to reach the previous peak, traders decide to exit the market, bringing the currency pair prices down. The neckline in this pattern confirms the Head and Shoulders pattern as it is drawn underneath the price chart by connecting the troughs of the head peak. As and when the currency pair prices fall below this neckline, it confirms a strong downtrend indication and signals traders to sell the currency pair and exit the market.
- The pattern helps in identifying bearish reversals through the three consecutive high price points in the market, after which the prices decline
- The pattern helps in identifying bullish reversals through the three consecutive low price points in the market, after which the prices increase
Inverse Head and Shoulders pattern
The inverse Head and Shoulders pattern is formed during a downtrend. It is an uptrend trend reversal signal. It predicts bearish to bullish trend reversals and provides traders with ideal entry points in the market. This pattern works in the exact opposite way of a Head and Shoulders pattern, forming three low peaks in the market and indicating a bullish reversal.
- The currency pair prices drop and witness a temporary rise, which forms the left shoulder in the pattern.
- The prices continue to fall once again, forming a brand new low and witnessing another temporary increase in the price, forming the head.
- At last, the price drops but does not fall beyond the previous low and rallies back up again, forming the right shoulder and indicating a strong uptrend thereafter. This signals traders to place buy orders and enter the market.
The neckline in the inverse Head and Shoulders pattern is formed by joining the peaks of the head. The uptrend is confirmed right after the currency pair prices move beyond the neckline.
Factors affecting the Head and Shoulders pattern
1. Left shoulder
When formed during an uptrend, the left shoulder marks the first high point in the bullish trend. A decline follows after this peak to complete the Head and Shoulders formation, signaling traders the first bearish phase in the pattern and the first point of the neckline.
2. Right shoulder
When formed during an uptrend, the right shoulder marks the third high point in the bullish trend. This is followed by a final decline in the prices which confirms the bearish trend reversal and pattern completion.
The head is the second peak in the pattern, which is the highest amongst them all during an uptrend. After the peak, it is followed by a temporary decline which is also the second point of the neckline and contributes to an important element in the trend.
4. Prior trend
The prior trend in the market defines if the Head and Shoulders pattern is going to signal a bullish trend reversal or a bearish trend reversal. Only when a strong trend exists the pattern will work as a reversal pattern.
The neckline is formed by connecting either two low points in an uptrend or two high points in a downtrend. The first point marks the end of the left shoulder, and the second point marks the end of the head. The more downward sloping this neckline is, the stronger the bearish trend reversal is.
Volume plays the most important role in a Head and Shoulders pattern because only when the volume is high in the market the peaks become reliable for traders to make decisions. The confirmation comes when the volume increases during both a downtrend and an uptrend.
7. Neckline break
The neckline break, also called the neckline support, is the price below which the currency pair does not drop during the Head and Shoulders pattern. The trend reverses as soon as the neckline break is surpassed, and the Head and Shoulders pattern confirms the reversal.
8. Price target
As soon as the currency pair price surpasses the neckline break, the future price is predicted by calculating the distance between the neckline and the head’s peak. The distance is subtracted from the neckline to calculate the price target, based on which traders make entry or exit decisions.
9. Support and resistance
As soon as the currency pair price breaks its support level in a Head and Shoulders pattern, an uptrend is confirmed and signals traders to place buy orders. However, in an inverse Head and Shoulders pattern, as soon as the currency pair price breaks its resistance level, a downtrend is confirmed that signals traders to place sell orders.
Top Head and Shoulders strategies
1. Trend Reversal Head and Shoulders strategy
Head and Shoulders are itself a trend reversal pattern, and hence, the Trend Reversal Strategy assists traders in analyzing the potential breakout point to enter or exit a trade. The trendline is formed by connecting the highest lows in the bullish trend or the lowest highs in a bearish trend. Short trades can be entered whenever the currency pair prices dip lower than the trendline, making a new low and stop-loss orders can be placed at the latest high price point in the chart. The trend reversal strategy helps traders identify the most reliable Head and Shoulders Pattern in the chart by shifting their focus on the lowest highs and highest lows only.
2. Inverse Head and Shoulders Volume Strategy
The inverse Head and Shoulders pattern combined with trade volume provides traders with a bullish trend reversal signal. The higher the volume in this pattern, the closer the pattern trades around a strong support level. This indicates an uptrend trend reversal, where traders can enter a long position right at the right shoulder’s low. The stop-loss order can be placed at the head’s low point, and the take profit order can be placed at 1.5 times the stop loss level. All in all, this strategy helps traders enter a bullish trend reversal or exit the continued bearish market, as per their trading goals.
3. Aggressive Reversal Head and Shoulders strategy
The Aggressive Reversal Head and Shoulders strategy is applied when there are two consecutive highs in the market with an ongoing bullish trend.This strategy allows aggressive orders during strong uptrends and downtrends as it confirms bullish or bearish trend reversals as soon as the three peaks are formed. Connect the two highs to form the trendline, which will signal an entry point at the right shoulder high. The stop-loss order can be placed equal to the distance between the head and the neckline.
4. Zig-zag Head and Shoulders strategy
The Zig-zag Head and Shoulders strategy enables traders to identify the ideal highs and lows on the chart, enabling them to place trade orders accordingly. The highs and lows are then used to plot the shoulders and the middle head. In this strategy, there are always at least 15 candles in between both the shoulders and head. The neckline is drawn by connecting the base of the two shoulders, and a trade entry order can be placed as soon as the currency pair price moves below the neckline. The stop-loss order can be placed at the head. Multiple time frames can be used in this strategy to confirm the Head and Shoulders pattern and the reversal signals.
5. Renko Charts Head and Shoulders strategy
The Renko charts Head and Shoulders strategy helps traders filter out any noise or irrelevant price fluctuations in the market to provide them with the precise and strong market trend. It does not follow any particular timeframe or trade volume and is only dependent on the actual price fluctuations in the market. It also helps spot the support and resistance levels, which helps traders place buy or sell orders. An entry order can be placed at the neckline when trading the inverse Head and Shoulders, whereas a stop-loss order can be placed at the latest low. Take profit orders are best suited in this strategy when placed two times above the stop loss level.
6. First Pullback strategy
After a Head and Shoulders pattern forms, there is also a possibility of a further breakdown that is followed by a pullback. In this situation, traders can short the trade at the swing lows and set stop-loss orders above the highs of the Head and Shoulders pattern. Traders can wait for the price to come above the neckline to place any long orders and time their entries accordingly.
7. Pre-neckline Short Trade strategy
The Pre-neckline Short Trade Head and Shoulders strategy enables traders to short the pattern even before the currency pair prices reach the neckline. This can be done by placing a short order right after the left shoulder and the head is formed, and prices continue to rally. Short the trade at the left of the head and set your stop-loss order above the swing high to chase the market.
Use the Head and Shoulders strategy today to spot reversals
The Head and Shoulders pattern helps traders identify market trend reversals and place buy and sell orders accordingly. Trade with Blueberry Markets to start experimenting with the Head and Shoulders pattern. Sign up for a live trading account or try a risk-free demo account today.
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