A head and shoulders pattern is a technical chart pattern used to predict a bullish-to-bearish trend reversal. It is made up of three peaks: two similar-sized peaks on the sides and a taller peak in the middle.

To form a head and shoulders pattern, a stock’s price initially rises to a peak and then falls back to its starting point. Next, it rises higher than the first peak, creating the “head,” and then falls back to the original base. Finally, the stock price reaches a third peak around the same level as the first before declining again.

The head and shoulders pattern is widely recognized as one of the most reliable indicators of a trend reversal. Among various technical patterns, it’s considered a top signal, though not always foolproof, that an uptrend is nearing its end.

Understanding the Head and Shoulders Pattern

The head and shoulders usually comprises of four formation steps. Following prolonged uptrends, the price reaches a high point and then falls to a low point.

Afterward, the price climbs to a new high significantly higher than the previous one and then falls again. For the third time, the price rises but only reaches the level of the first peak before declining once more. The neckline is a horizontal line connecting the two low points or the two high points.

The head is typically the highest peak. The neckline acts as a support level during the uptrend and often becomes resistance after the pattern completes.

Here are parts of the pattern:

Left Shoulder: The first peak in the pattern, often referred to as the “left shoulder,” marks the initial high point of the uptrend.

Head: The highest peak in the pattern is the “head,” representing a temporary reversal or pause in the uptrend.

Right Shoulder: The second peak, known as the “right shoulder,” is typically slightly lower than the head but still above the neckline.

Neckline: The neckline is a horizontal line connecting the troughs between the left shoulder, head, and right shoulder.

Additionally, a decrease in volume during the formation of the head and shoulders can strengthen the bearish signal.

How to Identify the Head and Shoulders Pattern

The head and shoulders pattern can easily be identified by spotting out its characteristics.

1. Locate a clear uptrend: Firstly, look for a well-established uptrend in the price chart.
2. Identify the left shoulder: Pinpoint the first significant high point in the uptrend.
3. Watch for the head: Look for a subsequent higher high that forms the head.
4. Observe the right shoulder: Identify a lower high that follows the head, forming the right shoulder.
5. Draw the neckline: Connect the troughs between the left shoulder, head, and right shoulder with a horizontal line.

How to Trade the Pattern

We advice that traders should be patient and wait for the entire pattern to form, as a pattern may not materialize at all or may remain incomplete. While partially formed patterns should be monitored, it’s advisable to avoid trading until the pattern breaks the neckline.

Once a head and shoulders pattern is confirmed, it suggests a potential reversal to a downtrend. Traders may consider selling or shorting the asset near the neckline or after a breakout below the neckline.

However, it’s important to use other technical indicators and risk management strategies to confirm the signal and minimize losses.

Once a trader has confirmed a head and shoulders pattern, several strategies can be employed to capitalize on the potential reversal:

Neckline Breakout Strategy

• Wait for the breakout: Monitor the price action as it approaches the neckline.
• Enter on a break below: When the price decisively breaks below the neckline and closes below it, consider entering a short position.
• Set a stop-loss: Place a stop-loss above the highest point of the right shoulder to manage risk.
• Determine a profit target: Use technical indicators or price projection methods to set a profit target.

Pullback Strategy

• Anticipate a pullback: After the price breaks below the neckline, it may experience a temporary pullback or retracement.
• Enter on the pullback: If the price retraces back to the neckline or a nearby resistance level, consider entering a short position.
• Set a stop-loss: Place a stop-loss above the recent high or a previous resistance level.

Conclusion

A head and shoulders pattern is a technical analysis tool that indicates a potential reversal from an uptrend to a downtrend. It’s characterized by three distinct peaks: two similar-sized peaks on the sides and a taller peak in the middle.

The pattern forms as the price rises, falls, and rises again, creating a distinctive shape. Once the pattern is complete, the neckline, a horizontal line connecting the low points, often becomes resistance. The head and shoulders pattern is considered a reliable indicator of a trend reversal, although it’s important to use it in conjunction with other technical analysis tools and apply efficient risk management to achieve the best results.

See other chart patterns like the inverted head and shoulders in our comprehensive glossary.