How To Trade Head And Shoulders Pattern?

I have been asked by many readers that why I haven’t posted anything related to personal experience & learning and education when my main aim was to educate the traders and maximize their wealth. Well after starting this trading blog, I got so excited that I started posting on live trade setups in stocks, commodities and forex to help traders take a plunge. Well its better late than never. From on now I will post my interesting learning notes and experience based on which I have started my trading career – we will call this section as Tradology! Lets start with one of my most favorite chart pattern – Head and Shoulders.

A Head and Shoulders pattern is considered a bearish signal. It indicates a possible reversal of the current uptrend to a new downtrend. The Head and Shoulders is an extremely popular pattern because it’s one of the most reliable of all formations. It also appears to be an easy one to spot but it’s not as it’s tough to spot real occurrences. The classic Head and Shoulders pattern looks like a human head with shoulders on either side of the head. It’s basically a pattern which has three sharp high points, created by three successive rallies with decreasing volumes.

Head and Shoulders Chart Pattern

The first point – the left shoulder – occurs as the price in a rising market hits a high and then falls back. The second point – the head – happens when prices rise to an even higher high and then fall back again. The third point – the right shoulder – occurs when prices rise again but don’t hit the high of the head. Prices then fall back again once they have hit the high of the right shoulder. The shoulders are definitely lower than the head and, in a classic formation, are often roughly equal to one another.

A key element of the pattern is the neckline. The neckline is formed by drawing a line connecting two low price points of the formation. The first low point occurs at the end of the left shoulder and the beginning of the uptrend to the head. The second marks the end of the head and the beginning of the upturn to the right shoulder. The neckline can be horizontal or it can slope up or down. The pattern is complete when the support provided by the neckline is broken and the price closes below it.

The neckline can slope up or down. An upward sloping neckline is considered to be more bullish than a downward sloping one, which indicates a weaker situation with more drastic price declines. It is rather rare to have a downward sloping neckline for this pattern.

The right and left shoulders peak at approximately the same price level and the shoulders are often about the same distance from the head. In other words, there should be about the same amount of time between the development of the top of the left shoulder and the head as between the head and the top of the right shoulder. In the reality, there might not be so much symmetry.

Variations of a Head and Shoulders Pattern

Following are some variations of the Head and Shoulder pattern that may occur.

The Drooping Shoulder

The drooping shoulder, where the neckline has a downward slope, is highly unusual and demonstrates extreme weakness. The droop happens because the price at the end of the head and the beginning of the right shoulder has dropped even lower than the previous low at the end of the left shoulder and the beginning of the head. Mostly the downward slope has bearish implications for market weakness. When the right shoulder is drooping, the trader will have to wait longer than usual for a decisive neck break. It should also be noted that when that decisive break does occur much of the move will have already occurred.

Varying Width of Shoulders

The classic Head and Shoulders pattern is symmetrical. However, if the shoulders don’t match in width, don’t discount the pattern.

Flat Shoulders

While the classic Head and Shoulders pattern is made up of three sharp upward points, these need not be present for the pattern to be valid. Sometimes, shoulders can be rounded.

Multiple Head and Shoulders Patterns

Many valid Head and Shoulders patterns are not as well defined as the classical head with a shoulder on either side. It is not uncommon to see more than two shoulders and more than one head. A common version of a multiple Head and Shoulders pattern includes two left shoulders of more or less equal size, one head, and then two right shoulders that mimic the size and shape of the left shoulders.

Volume Implication

Volume is extremely important for this pattern. For a Head and Shoulders pattern the volume is highest when the left shoulder is forming. In fact, volume is often expanding as the uptrend continues and more and more buyers want to get in. Volume is lowest on the right shoulder as investors see a reversal happening. Mostly, low volume levels on the right shoulder are a strong sign of a reversal. In the head portion of the price pattern, volume falls somewhere between the strength of the left shoulder and weakness of the right shoulder. Volume often increases when the neckline is broken as the reversal is now complete and downside pressure begins in earnest. One of the key characteristics looked for in a Head and Shoulders pattern is very high volume on the breakout.

Criteria that Confirm

Volume Spike on Confirmation

A strong volume spike on the day of the pattern confirmation is a strong indicator in support of the potential for this pattern. The volume spike should be significantly above the average of the volume for the duration of the pattern.

Moving Average Criteria

The Head and Shoulders pattern should be above the 50 day Moving Average for a short term trade setup and above 200 day Moving Average for a long term trade setup. The Moving Average should change direction within the duration of the pattern and should head in the direction indicated by the pattern.

Criteria that Refute

No Volume Spike on Confirmation

The lack of a volume spike on the day of the pattern confirmation is an indication that this pattern may not be reliable. In addition, if the volume has remained constant, or was increasing, over the duration of the pattern, then this pattern should be considered less reliable.

Moving Average Criteria

If the Head and Shoulders pattern is below the Moving Average then this pattern should be considered less reliable. A Moving Average that is trending in the opposite direction to that indicated by the pattern is an indication that this pattern is less reliable. Look at the direction of the Moving Average Trend. For short term trade setup use a 50 day Moving Average and for a long term trade setup use a 200 day Moving Average.

Target and Stop Loss

Head and Shoulders chart pattern break out

Target and Stop loss is very subjective on the basis of one’s trading style. But mostly in Head and Shoulders pattern the difference between the head and low point of either shoulder is subtracted from the neckline breakout level on the down side to provide a price target.

Now it’s your turn…..

Feel free to share your experience and thoughts in the comments area.

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