HOW TO TRADE HEAD AND SHOULDERSCHART PATTERN

in-depth tutorial

HEAD AND SHOULDERS EXPLAINED

HEAD AND SHOULDERS ILLUSTRATION

Bearish "Head and Shoulders" chart pattern illustration
Direction: Reversal
Type: Bearish
Occurrence: Low
Common term: Medium - Long

HEAD AND SHOULDERS PRICE ACTION STRUCTURE

  • In an uptrend, price action finds first resistance 1 that forms left shoulder's high, where it reverse direction and goes downwards till finding support 2, completing the left shoulder formation.
  • Price action reverses direction from that support 2 and goes upwards till finding second resistance 3 that forms head's high, where it reverses direction and goes downwards till finding support 4, completing the head formation.
  • Price action reverses direction from the last support 4 and goes upwards till finding third resistance 5 that forms right shoulder's high, where it reverses direction going downwards.
  • The pattern is completed when price action breaks the neckline at point 6 downwards.

NOTES ON HEAD AND SHOULDERS

  • Neckline is identified by drawing a trend-line connecting the two support levels that completed both the left shoulder and head formations, which are (2 - 4).
  • Both shoulders don't have to be of the same height.
  • Neckline can be skewed, usually to the same direction of the trend-line connecting both shoulders highs at points (1 - 5).
  • Volume usually decreases as the pattern is being formed, and increases when breaking or retesting the neckline.
  • This pattern is commonly found on medium and long-term time-frames.

HOW TO TRADE HEAD AND SHOULDERS

  • Trade entry: the pattern is traded after price action breaks the neckline at point 6, either with an entry after the breakout, or after a -possible- retest to the neckline which turned into resistance.
  • Take profit: identified by measuring the vertical distance from head 3 to neckline, that measurement is then applied from the breakout point 6.
  • Stop loss: can either be the neckline breaking rate 6, or the right shoulder's high 5.

HEAD AND SHOULDERS REWARD:RISK

  • When using the right shoulder as stop loss, the pattern's R:R will be better when the shoulder's retracement distance (4 - 5) is short compared to the (head - neckline) distance.
  • When using the neckline breaking rate as stop loss, the pattern's R:R will depend on the (entry rate - breaking rate) distance, compared to (head - neckline) distance.
  • Always remember that both stop loss levels explained above are absolute, the actual stop loss rate for your trade setup should be a bit beyond those levels to give the trade setup some room to breathe, and of-course calculations for position size and R:R should be done with respect to those rates.

HEAD AND SHOULDERS REAL EXAMPLE

Real example for bearish "Head and Shoulders" chart pattern, using the daily chart of AUD/USD on Oanda's MT4 platform
Currency pair: AUD/USD
Timeframe: D1
Breakout: 21-Nov-2013
Platform: MT4
Broker: Oanda

HEAD AND SHOULDERS FOREX TRADE SETUP

  • Trade entry: at the closing rate of the candle after breaking the neckline at point 6
  • Take profit: 398.0 pips - usual measurement applied from point 6
  • Stop loss 1: 159.1 pips (R:R 2.502) - set at 14% of target measurement, beyond absolute SL1
  • Stop loss 2: 311.7 pips (R:R 1.277) - set at 7% of target measurement, beyond absolute SL2

INVERSE HEAD AND SHOULDERS

INVERSE HEAD AND SHOULDERS ILLUSTRATION

Bullish "Inverse Head and Shoulders" chart pattern illustration
Direction: Reversal
Type: Bullish
Occurrence: Low
Common term: Medium - Long

INVERSE HEAD AND SHOULDERS PRICE ACTION STRUCTURE

  • In a downtrend, price action finds first resistance 1 that forms left shoulder's low, where it reverse direction and goes upwards till finding support 2, completing the left shoulder formation.
  • Price action reverses direction from that support 2 and goes downwards till finding second resistance 3 that forms head's low, where it reverses direction and goes upwards till finding support 4, completing the head formation.
  • Price action reverses direction from the last support 4 and goes downwards till finding third resistance 5 that forms right shoulder's low, where it reverses direction going upwards.
  • The pattern is completed when price action breaks the neckline at point 6 upwards.

INVERSE HEAD AND SHOULDERS REAL EXAMPLE

Real example for bullish "Inverse Head and Shoulders" chart pattern, using the H4 chart of USD/CHF on XM's MT4 platform
Currency pair: USD/CHF
Timeframe: H4
Breakout: 24-Aug-2016
Platform: MT4
Broker: XM

INVERSE HEAD AND SHOULDERS FOREX TRADE SETUP

  • Trade entry: at the closing rate of the candle after breaking the neckline at point 6
  • Take profit: 95.8 pips - usual measurement applied from point 6
  • Stop loss 1: 37.5 pips (R:R 2.555) - set at 14% of target measurement, beyond absolute SL1
  • Stop loss 2: 76.9 pips (R:R 1.246) - set at 7% of target measurement, beyond absolute SL2

NOTES ON THIS TRADE SETUP

  • Pattern retested neckline twice, second retest almost hit SL1.
  • This pattern's duration and pip range is much less than what is common for an inverse head and shoulders, making it more vulnerable to higher-than-usual market volatility, an example of that is how close was the second retest from hitting SL1.