The most accurate signals in technical analysis are given by specific patterns that are formed during the chart movement. Let's talk about probably the most famous of them - Head and shoulders.
Types of Figure
This element of chart analysis appears quite rare on the market in its pure form, although it is considered common. Traders often use the line chart to detect it. It is much easier to define the pattern there.
However, most traders find Head and shoulders pattern on the Japanese candlestick chart. The patterns formed by candles often help confirm the main pullbacks in the figure.
This model is of two types:
- Basic pattern. This pattern is formed after an uptrend and indicates an imminent change to a downtrend.
- Inverse Head and Shoulders. The figure is the complete opposite of the previous one. Appears on a descending trend and signals about its change to the uptrend.
The Structure of Both Figures
The pattern is formed from three peaks. The one in the middle must be higher than the other two. This is the basic requirement for the figure.
The basic pattern is formed on a bullish trend. The right and left peaks are called “shoulders”. The high middle peak forms the “head”. The two troughs below, on either side of the middle peak, form the base called the “neckline”. This level later becomes the support level. The breakout or testing of this line will be the main signal for opening a position.
Head and Shoulders Figure
The inverse model completely mirrors the previous pattern. The model appears on a bearish trend. Its “head” is formed by the deepest trough. Its bottom edge is at the extreme low. The two troughs on the right and left are slightly shallower. They form the “shoulders” of the inverse model. The two peaks on either side of the head draw the neckline that forms the resistance level. Its breakout will be the main signal to enter the trade.
Inverse Head and Shoulders Figure
Trading Strategy
If you are lucky enough to catch the formation of this pattern, then there are several important rules to follow. This is the only way you can get high profits instead of significant losses.
Our pattern gives two main signals:
- Breakout signal. For the base model, this will be a breakout of support at the neckline. Open a sell trade. For an inverse pattern, breaking the resistance at the neckline gives a buy signal. You can prepare in advance for this signal at the end of the second shoulder formation.
- Pullback to the neckline. Price often returns to this level for retesting. It is necessary to wait for a bounce from the line. For the basic pattern, when the price bounces from the resistance, open a short position. For the inverted model, price bounces up from the support at the neckline. This is a signal to open a long position.
Everything is clear with the open level. Let's define an exit point. The distance to your Take Profit should be equal to the distance from the neckline to the high or low of the head (depending on the pattern type). If you don’t use TP (which I strongly advise you not to do), then you should constantly monitor your position. This is the only way you can protect your profits.
For the basic pattern, set the Stop Loss right above the neckline. Set it just below this level for the inverse model.
Remember that price often returns to the neckline for retesting. Don't panic. The market will most likely turn in the right direction again. Otherwise, you have your Stop Loss set.
The Pattern on the Chart
Additional Confirmation of Signals
There are several ways to confirm our pattern even during formation:
- You can use candlestick patterns on the highs and lows of the figure. For example, the appearance of a Doji at the top of the right shoulder indicates that the bulls are no longer able to push the price up. Uncertainty reigns in the market. Soon the chart will begin to fall and complete the formation of the pattern.
- You might also track the trading volumes using special indicators. As a rule, during the formation of the left side of the “head”, the trading volumes fall as the bulls lose strength. When the right side is formed, the volumes grow as the bears are actively entering the game. When the price passes the peak of the right shoulder, volumes reach their maximum which leads to the breakout of the support level at the neckline.
- Use the oscillators (for example, the RSI indicator). When the price leaves the overbought zone, the chart is likely to go down. This usually occurs around the peak of the second shoulder. In case of an inverse pattern, the oscillator will show leaving the oversold zone which gives a buy signal.
Both types of the pattern give fairly accurate signals that you can easily confirm in several more ways. This model doesn’t appear on the market often. Don't miss the opportunity to open a trade if you manage to catch it.
If you come across a figure with asymmetrical shoulders (which is much more common than the base model), make sure the neckline is horizontal and the head forms the largest peak.
That’s all you should know about this pattern. Good luck with trading!