A Head and Shoulders pattern is one of the most common trading patterns you’ll see on the charts. Due to its reliability and predictability, you can easily quit the unprofitable trend or even bet on the hard reversal that’s going to follow this pattern. It’s a chance you can’t miss.
Basically, this formation is one of the reversal indicators that show you exactly when a steadily positive trend is going to turn into a negative one. There are many of them, but this one should probably be one of the first you learn. It almost always proves correct, the only trick is to notice it before it’s too late.
How does it look?
H&S indicator looks like three consecutive peaks: a high price peak in the middle, and two smaller ones on each side of it. So, the formation opens up with a strong price surge, and then followed by a moderate dip, which is then transformed into a much bigger peak. The third one is usually a similar height as the first one.
The distances between the peaks don’t matter that much – they can differ substantially. Still, the left shoulder usually leads into the head within two weeks. Depending on the size of the market and the number of participants, the distances can naturally expand to even months, but it’s rare.
The distance between the beginning of the first Shoulder and the end of the third Shoulder is called a neckline. Normally, they are flat or close to that.
What’s the logic behind the pattern?
The reversal patterns are normally similar in logic to one another, but the precious part about the Head and Shoulders pattern is that market participants give themselves enough time to act. This is what usually happens:
- The first Shoulder has reached a long bullish (positive) trend. Either because the price has reached the resistance levels or because of some unpredicted market action, the price is suddenly pulled back.
- During the first dip, participants sell the shares en masse, believing that it’s nearing failure.
- Closer to the Head, many more participants decide to give the still generally bullish trend one big push, thus creating a sudden upward shift;
- During the second dip, the bearish mood wins and the price moves proportionally down.
- The last Shoulder represents the last hope of stabilizing the trend. It’s still positive at this point.
After the right shoulder, the price starts to definitively move downwards. That is, it will if the pattern indeed turns out to be Head and Shoulders. It will always make sense when it’s already passed, and the market has already entered the bearish mood. However, it’s not that clear while it’s still developing, and traders often tend to turn the tide up.
Usually, more people bail, however, which often helps the pattern to develop fully. Again, since it takes many days for it to formulate, you can spot it with relative reliability. But even when you do, what do you actually do next?
Using the pattern
These reversal patterns are normally used to quit the trend that went bad. You basically sell your assets during one of the peaks because you know the market will soon turn bearish, and it’s better to quit sooner than later.
In addition to that, advanced traders can instead enter the market with a short trade. This way, you actually want the stock to lose all value. Patterns like this create a golden opportunity for it because you know that the price is going to fall dramatically after the third peak.
You don’t really know how long this bearish trend is going to last, but it’s normally smooth so if it’ll start to even out, so you’ll notice it fairly soon. You really don’t want to trade short for too long because a bearish momentum that breaks the price after the third peak won’t last forever.
When do I quit/enter?
There are several points across the Head and Shoulders pattern where you can quit or enter the market based on your goals. There are optimal spots, but you won’t lose much if you act a bit sooner or a bit later.
- The most optimal spot would be on the Head or before the second Shoulder. At this point, it’s usually evident that the pattern is going to form because it fails very rarely past this point. The absolute best is the candlestick right after the highest peak because it won’t rise higher and you can sell at almost the biggest value.
- The second-best spot would be right after the second Shoulder. At this point, it’s absolutely obvious that the Head and Shoulders just happened, and everyone who still remains on the market will bail. Most people likely already bailed, but the second Shoulder exists because people commonly still have some hope.
- The worst place would be to bail anywhere before the Head. At this point, the pattern has not been proven yet, and you risk losing potential profits. It’s not as bad as losing the money you owned prior to entering the market, but it’s still unfortunate.
It really doesn’t matter whether you want to enter or quit at any of these points. They work with similar effectiveness regardless of your intentions. For both approaches, it’s a question between absolute profits and absolute safety. Picking the most optimal spot gives you the most gains. The second-best spot gives more surety, however.
Inverse H&S
In addition to the classic Head and Shoulder, you can also encounter an inverse Head and Shoulders pattern. It’s not as common, but it’s just as reliable because it represents the same principles as the one that was just described.
It’s basically the same pattern, but in a bearish environment. Instead of signaling an incoming bearish turn, it heralds a future bullish shift.
Instead of the peaks, the reverse type is formed by a giant drop, joined on each side by smaller, similarly-sized drops. Normally, the last drop will open into a stable bullish trend, which creates a perfect situation for a classic long trade. You could likewise enter the market at any of the points listed above, except mirrored for an inverse pattern.
In conclusion
Due to its long conception, multiple opportunities, and a high chance of successful formulation, the Head & Shoulders pattern is considered one of the most lucrative and useful candlestick formations in trading as a whole. If you notice one of these, consider it your lucky day and proceed as instructed.
