How to Trade the Head and Shoulders Pattern

The head and shoulders chart pattern is a popular and easy-to-spot pattern in technical analysis. It shows a baseline with three peaks with the middle peak being the highest. The head and shoulders chart pattern depicts a bullish-to-bearish trend reversal and it signals that an upward trend is nearing its end.

The pattern appears on all time frames so it can be used by all types of traders and investors. Entry levels, stop levels, and price targets make the formation easy to implement because the chart pattern provides important and easily visible levels.

What the Head and Shoulders Pattern Looks Like

Formation of the pattern seen at market tops:

• Left shoulder: Price rise followed by a price peak, followed by a decline
• Head: Price rises again forming a higher peak
• Right shoulder: A decline occurs once again followed by a rise to form the right peak which is lower than the head

Formations are rarely perfect. There may be some noise between the respective shoulders and head.

Inverse Head and Shoulders Pattern

Formation of the inverse head and shoulders pattern seen at market bottoms:

• Left shoulder: Price declines followed by a price bottom, followed by an increase
• Head: Price declines again forming a lower bottom.
• Right shoulder: Price increases once again then declines to form the right bottom.

Again, there may be some market noise between the respective shoulders and head.

Placing the Neckline

The neckline is the level of support or resistance that traders use to determine strategic areas to place orders. The first step in placing the neckline is to locate the left shoulder, head, and right shoulder on the chart.

We connect the low after the left shoulder with the low created after the head in the standard head and shoulders pattern (market top). This creates our neckline, the dark blue line on the charts.

We connect the high after the left shoulder with the high formed after the head in an inverse head and shoulders pattern. This creates our neckline for this pattern.

How to Trade the Pattern

Traders must wait for the pattern to complete because a pattern may not develop at all or a partially developed pattern may not complete in the future. Partial or nearly completed patterns should be watched but no trades should be made until the pattern breaks the neckline.

We're waiting for price action to move lower than the neckline after the peak of the right shoulder in the head and shoulders pattern. We wait for price movement above the neckline after the right shoulder is formed for the inverse head and shoulders pattern.

A trade can be initiated when the pattern is completed. Plan the trade, writing down the entry, stops, and profit targets as well as noting any variables that will change your stop or profit target. The most common entry point is when a breakout occurs: The neckline is broken and a trade is taken.

Another entry point requires more patience and comes with the possibility that the move may be missed altogether. This method involves waiting for a pullback to the neckline after a breakout has already occurred. This is more conservative because the trade may be missed if the price keeps moving in the breakout direction and we can see if the pullback stops and the original breakout direction resumes.

Placing Your Stops

The stops are placed just above the right shoulder or topping pattern after the neckline is penetrated in the traditional market top pattern or the head of the pattern can be used as a stop. This is likely a much larger risk, however, and it reduces the reward-to-risk ratio of the pattern.

The stop is placed just below the right shoulder in the inverse pattern. Again, the stop can be placed at the head of the pattern but this exposes the trader to greater risk. The stop would be placed at $104 just below the right shoulder in the above chart after the trade was taken.

Setting Your Profit Targets

The profit target for the pattern is the price difference between the head and the low point of either shoulder. This difference is then subtracted from the neckline breakout level at a market top to provide a price target for the downside. The difference is added to the neckline breakout price to provide a price target to the upside for a market bottom.

An example of the profit target for the inverse head and shoulders pattern would be:

$113.20 as the high after the left shoulder – $101.13 as the low of the head = $12.07

This difference is then added to the breakout price which is subtracted in the case of a regular head and shoulders pattern. The breakout price is right around $113.25, giving us a profit target of $125.32 ($113.25 + $12.07).

Why the Head and Shoulders Pattern Works

No pattern is perfect and they don't work every time but the chart pattern theoretically works for several reasons. We'll use the market top will for this reasoning but it applies to both:

• Sellers have begun to enter the market and there's less aggressive buying as price falls from the market high or head.
• Many people who bought in the final wave higher or bought on the rally in the right shoulder are now proven wrong and facing large losses as the neckline is approached. This large group will now exit positions, driving the price toward the profit target.
• The stop above the right shoulder is logical because the trend has shifted downward. The right shoulder is a lower high than the head. The right shoulder is therefore unlikely to be broken until an uptrend resumes.
• The profit target assumes that those who are wrong or purchased the security at a poor time will be forced to exit their positions. This will create a reversal of similar magnitude to the topping pattern that just occurred.
• The neckline is the point at which many traders are experiencing pain and will be forced to exit positions. This pushes the price toward the price target.
• Volume can be watched as well. We would ideally like the volume to expand as a breakout occurs during inverse head and shoulders patterns or market bottoms. This shows increased buying interest that will move the price toward the target. Decreasing volume shows a lack of interest in the upside move and warrants some skepticism.

The Pitfalls of Trading Head and Shoulders

You may encounter some potential problems with trading a head and shoulders pattern:

• You have to find patterns and watch them develop but you shouldn't trade this strategy until the pattern is completed. This could mean a long period of waiting.
• It won't work all the time. The stop levels will sometimes be hit.
• The profit target won't always be reached so traders might want to fine-tune how market variables will affect their exit from the security.
• The pattern isn't always tradable. The calculated price targets probably won't be hit if there's a massive drop on one of the shoulders due to an unpredictable event.
• Patterns can be subjective. One trader may see a shoulder when another doesn't. Define what constitutes a pattern for you beforehand.

The Bottom Line

Head and shoulders patterns occur in all timeframes and can be seen visually. They're subjective at times but the complete pattern provides entries, stops, and profit targets, making it easy to implement a trading strategy.

The pattern is composed of a left shoulder, a head, then a right shoulder. The most common entry point is a breakout of the neckline with a stop above (market top) or below (market bottom) the right shoulder. The profit target is the difference between the high and low with the pattern added (market bottom) or subtracted (market top) from the breakout price.

The system isn't perfect but it does provide a method of trading the markets based on logical price movements.

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