Trading strategy for the Head and Shoulders pattern

Information is not investment advice

Introduction

In technical analysis, there are different chart patterns which help you to determine the further direction for the price. In the broadest sense, all of these patterns are divided into the two large groups: reversal and continuation chart patterns. You can learn how to define them in our Forex Guidebook. Today, we will present you the trading strategy for one of the most commonly known patterns. Of course, we are talking about the Head and shoulders pattern.

What is the Head and shoulders pattern?

What comes to your mind when you hear the words “head and shoulders”? If it is the smell of your favorite shampoo, then you don’t trade hard enough! The first thing which comes to the mind of a professional trader is, of course, the famous reversal pattern.

The head and shoulders pattern usually occurs at the end of the uptrend. You can easily spot it on any timeframe. It is formed by a peak (first shoulder), higher peak (head), and a lower peak (second shoulder).  You can draw a “neckline” by connecting the minimums of the left shoulder and the head.  The neckline shouldn’t be horizontal. Its slope may either be up or down. When the slope is down, the pattern provides a more reliable sell signal.

If you trade during the downtrend, you need to look for the inverse Head and shoulders pattern on the chart. This pattern is exactly opposite to the classic Head and shoulders pattern and may signal a bullish reversal.     

How the pattern is formed?

- When bulls get tired to ride a trend as a price becomes unbearably high for the current market conditions, bears come into play and try to pull the price down.  If the price tests the downside and then bounces back, it creates the left shoulder of the pattern.

- After that, bulls make their final attempt to push the price higher. That’s how the “head” of the pattern is formed.

- However, bulls cannot hold a price at such a high level and bears make the price to fall back to create the continuation of the neckline.

- “Alright, now these horned animals gave up completely”, - you thought. And you were wrong! Buyers try again with their weaker forces to push the price to a new high. But this high comes out lower than the “head”. This is the right shoulder of the pattern.

- Then bears take over and pull the price lower. Their pressure is too strong and they manage to break the neckline.

- Sometimes, the price may go up again with a lower volume and retest the neckline.  This small rise offers an opportunity to open a short position with the stop loss placed above the neckline. But this situation does not occur every time the Head and shoulders is formed.

- Bears push the price further down.

How to trade this pattern

There are several strategies to trade the Heads and Shoulders pattern. We will introduce you the easiest ones. The strategies listed below are universal: they may be applied to any currency pair, stock or commodity on any timeframe and they do not require additional indicators.

1. Wait for the pattern to be implemented. Do not take any trade until the pattern is completely formed.
2. Wait for a candlestick to break the neckline to the downside.
3. Place a sell order at least 3-5 pips under the neckline.
4. Put a stop loss 3-5 pips above the neckline.
5. The profit target is usually set as a price difference between the head and the neckline. Then this difference is subtracted from the breakout of the neckline to provide a price target to the downside.

Let’s look at the 4-hour chart for USD/JPY.  We can see, that the Head and shoulders pattern was implemented.

Bulls could not hold the price at the highs at 114.54 and the pair fell below the neckline at 113.56. We opened a sell order after the break of the neckline, 5 pips below it at 113.51.   We set our stop loss 5 pips above the neckline at 113.66. Then we counted the level of our take profit using the following formula:

114.54 (the top of the “head”) – 113.56 (the neckline) = 0.98

113.640-0.98=112.66

Success! You’ve earned around 100 pips!

You can use this strategy for the inverse Head and Shoulders, too. Here are the steps:

1. Wait for the pattern to be implemented.
2. Wait for a candlestick to break the neckline to the upside.
3. Place a buy order at least 3-5 pips above the neckline.
4. Put a stop loss 3-5 pips below the neckline.
5. Set the profit target as the difference between the bottom of the head and the neckline.

On the H4 chart of USD/CAD, we can see the Head and shoulders pattern. We see, that the neckline is not so perfect, but its slope goes up, which means the reversal is likely to happen.

We place a stop loss at 1.2653 and wait for the breakout of the neckline. When the candlestick is formed, we open a long order at 1.2663. We count our take profit:

1.2658 (the neckline) - 1.2528 (the head) = 0.0130

1.2658+0.013=1.2788.

Using this strategy, you earned 130 pips.

Conclusion

The Head and shoulders pattern is noticeable on the chart and provides a good opportunity for profitable trading with limited risks.

FBS Analyst Team

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