The head-and-shoulders pattern appears on all times frames and can therefore be used by day and swing traders as well as investors. Entry levels, stop levels and price targets make the formation easy to implement as the chart pattern provides important and easy-to-see levels. Investors are considering head-and-shoulders most of the time when they talk about  getting in low or picking entry and exit points. 

How Does the Pattern Look Like?

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Head-and-shoulders pattern suggest overbought market.It therefore signals a selling opportunity.

The formation of the head and shoulders pattern and the inverse head and shoulders is as follow:

• • Left shoulder: Price rise followed by a left price peak, followed by a decline.
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  • Head: Price rise again forming a higher peak.
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  • Right shoulder: A decline occurs once again, followed by a rise forming the right peak which is lower than the head.
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• Formations are rarely perfect, which means there may be some noise between the respective shoulders and head.

In practice, head-and-shoulders pattern are frequently seen on the forex chart in the form below:

Inverse Head-and shoulders pattern

It is usually observed at the market bottom. It tends to suggest oversold market.
Its formation is as follow:

Left shoulder: Price declines and moves higher.

Head: another Decline occurs to a lower level.

Right shoulder: Price then moves higher and moves back lower, but not as low as the head.

Again, formations are rarely perfect. There may be some market noise between the respective shoulders and head.

In practice,inverse  head-and-shoulders pattern are frequently seen on the forex chart in the form below:

Drawing  the Neckline

The first step is to locate the left shoulder, head and right shoulder on the chart. In the standard head and shoulders pattern (market top), we connect the low after the left shoulder with the low created after the head. This creates our "neckline" - the yellow line on the charts. We'll discuss the importance of the neckline in the following section. In a reverse head-and-shoulders pattern, we connect the high after the left shoulder with the high formed after the head thus creating our neckline for this pattern.

How to Trade the Pattern

It is very important that traders wait for the pattern to complete. One should not assume that a pattern will develop, or that a partially developed pattern will become complete in the future. Partial or nearly completed patterns should be watched, but no trades should be made until the pattern breaks the neckline. In the head and shoulders we are waiting for price action to move lower than the neckline after the peak of the right shoulder. For the inverse head and shoulder, we wait for price movement above the neckline after the right shoulder is formed.

A trade can be initiated as the pattern completes. Plan the trade beforehand, writing down the entry, stops and profit targets and noting any variables that will change your stop or profit target.

The most common entry 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 all together. This method involves waiting for a pullback to the neckline after a breakout has already occurred. This is more conservative in that we can see if the pullback stops and the original breakout direction resumes, but it also means the trade may be missed if the price keeps moving in the breakout direction.

Placing Your Stops

In the traditional market top pattern, the stops are placed just above the right shoulder (topping pattern) after the neckline is penetrated. Alternatively the head of the pattern can be used as a stop, but this is likely a much larger risk and thus reduces the reward to risk to ratio of the pattern. In the inverse pattern, the stop is placed just below the right shoulder. Again, the stop can be placed at the head of the pattern, although this does expose the trader to greater risk.

Setting Your Profit Targets

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

Why the Head-and-Shoulders Pattern WorksNo pattern is perfect, nor does it work every time. Yet there are several reasons why the chart pattern theoretically works (the market top will be used for this reasoning, but it applies to both):

• As price falls from the market high (head), sellers have begun to enter the market and there is less aggressive buying.
• As the neckline is approached, 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 – it is this large group which now will exit positions driving the price towards the profit target.
• The stop above the right shoulder is logical because the trend has shifted downwards – the right shoulder is a lower high than the head - and therefore the right shoulder is 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, thus creating a reversal of similar magnitude to the topping pattern which just occurred.
• The neckline is the point at which many traders are experiencing pain and will be forced to exit positions, thus pushing the price towards the price target.
• Volume can be watched as well. During inverse head and shoulder patterns (market bottoms), we would ideally like the volume to expand as a breakout occurs. This shows increased buying interest that will move price towards the target. Decreasing volume shows lack of interest in the upside move and warrants some skepticism.

The Pitfalls of Trading Head-and-Shoulders

As stated, the pattern is not perfect. Here are some...Read more

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