The allure of “easy money” in trading is undeniable, especially when coupled with popular strategies like the head and shoulders pattern. However, before diving headfirst into the market with high hopes of effortless profits, it’s crucial to understand the nuances and realities of trading using this strategy.
The head and shoulders pattern is a widely recognized technical analysis pattern used by traders to identify potential trend reversals. Its distinct shape, resembling a head between two shoulders, often leads traders to believe that spotting and trading this pattern guarantees easy profits. But does it live up to the hype?
The Head and Shoulders pattern is a technical analysis pattern that appears as a baseline with three peaks, the middle peak being the highest peak, forming what looks like two shoulders and a head. The pattern is formed when the price of an asset is in an uptrend and then reverses, forming the left shoulder, followed by a new high forming the head, and then a decline forming the right shoulder. The neckline is formed by connecting the low points of the two troughs, forming a support level. The pattern is considered a trend reversal pattern, with the neckline acting as a critical support level. If the price breaks below the neckline, it could indicate a bearish trend, while a break above the neckline could signal a bullish trend. The pattern is one of the most widely recognized and studied patterns in technical analysis.
Understanding the Head and Shoulders Pattern
Formation: The head and shoulders pattern typically consists of three peaks – a higher peak (the head) flanked by two lower peaks (the shoulders). It signifies a potential trend reversal from bullish to bearish (or vice versa) when spotted in an uptrend or downtrend, respectively.Confirmation: To validate the pattern, traders look for a neckline connecting the lows of the two shoulders. A decisive break below (in a head and shoulders top) or above (in a head and shoulders bottom) the neckline confirms the pattern and signals a potential entry point for trades.Target and Stop-loss: Traders often use the height of the pattern (from the head to the neckline) to project a target for profit-taking. Additionally, stop-loss orders are placed above the neckline (for short positions) or below the neckline (for long positions) to mitigate risk.
How to Identify Head and Shoulder Patterns
To identify a Head and Shoulder pattern, look for three peaks on the chart with a lower high in between. The two outside peaks should be close in height to one another, while the middle peak (the head) should be significantly higher than the other two. This indicates that there is potential for an upcoming trend reversal from bullish to bearish.
Alt: Illustration of how the Head and shoulders pattern is formed
How Head and Shoulder Patterns Signal Reversals
The Head and Shoulders pattern signals a potential trend reversal from bullish to bearish as the middle peak (the head) is significantly higher than the other two peaks. This indicates that, after reaching its peak, the price of the security is likely to decline. While the head and shoulders pattern is commonly associated with trend reversals, it can also appear within the context of an ongoing trend as a continuation pattern. In such cases, the pattern may signal a temporary pause in the trend before it resumes its original direction. It’s important to look at the broader context of the chart and consider other technical indicators and market factors before making any trading decisions based on the head and shoulders pattern.
Common Mistakes in Trading Head & Shoulders Patterns
Trading Head and Shoulders patterns can be tricky, as there is always the possibility of false signals. It’s important to keep in mind that Head and Shoulder patterns are not foolproof and should be monitored closely before taking action. Additionally, it is important to look at the overall trend of the market when identifying Head and Shoulder patterns, as this can help to distinguish between a true Head and Shoulder pattern and a false one.
Advantages and Disadvantages of the Head and Shoulders Pattern
Advantages:
- Reversal Signal
Head and shoulder patterns are commonly viewed as reliable indicators of trend reversal, particularly at the end of an uptrend. - Clear Pattern
The pattern is visually distinct, consisting of three peaks with the middle peak (the “head”) being higher than the other two (the “shoulders”), making it relatively easy to identify on price charts. - Price Target
Traders can use the pattern’s structure to estimate a potential price target for the subsequent move after the pattern completes, aiding in setting profit targets. - Confirmation
The pattern typically comes with confirmation when the neckline, connecting the lows of the two troughs between the peaks, is breached, providing a clear entry signal for traders.
Disadvantages
- False Signals
While head and shoulder patterns are considered reliable, they are not infallible, and there can be instances where the pattern fails to result in a significant reversal, leading to potential losses if trades are entered prematurely. - Subjectivity
There can be variations in how head and shoulder patterns appear on different charts, leading to subjectivity in their identification and interpretation. - Complexity
In some cases, head and shoulder patterns may not form as cleanly as depicted in textbook examples, leading to ambiguity in their interpretation and potential missed opportunities for traders. - Market Noise
Like any technical pattern, head and shoulders formations can be obscured by market noise, false breakouts, or erratic price movements, making it challenging to accurately time entries and exits solely based on the pattern
What Is the Opposite of a Head and Shoulders Pattern?
The inverse head and shoulders pattern is the opposite of the head and shoulders, indicating a reversal from a bearish trend to a bullish trend.
Alt: The inverse head and shoulders pattern illustration
In Conclusion
The head and shoulders is a pattern used by traders to identify price reversals. A bearish head and shouders has three peaks, with the middle one reaching higher than the other two. It indicates a reversal of an upward trend.
A bullish head and shoulders has three troughs, with the middle one reaching lower than the other two. It indicates a reversal of a downward trend.
