Head and Shoulders Pattern

The head and shoulders pattern resembles three peaks on a graph. It has a higher peak in the middle and two smaller peaks on either side. The higher peak is referred to as the “head” and the smaller peaks referred to as the “shoulders.” 

When this pattern is identified, and the price falls below the neckline, it could be an indication that the bears are in control. This article explains what is a head and shoulders pattern in detail. 

How does the Head and Shoulders Pattern Work? 

In order to understand how the head and shoulders pattern works, it is essential to understand how the pattern is formed on a price chart. 

How it Forms 

In most cases, the pattern develops after a strong upward trend. It usually appears in the following stages: 

• Left Shoulder: Price rises to a peak and then falls slightly. 
• Head: Price rises again to a higher peak than the first one and then declines. 
• Right Shoulder: Price rises for the third time but fails to reach the height of the head, forming a lower peak. 
• Neckline: A line drawn connecting the two lows between the shoulders and the head. 

This formation is easy to spot once you know what to look for. Many times, traders also analyse volume during this process. 

How it Works 

Once the price breaks below the neckline, the head and shoulders pattern is considered complete. This breakdown signals a potential shift in trend. 

Here’s why it works in many cases: 

• Buyers fail to push prices higher after forming the head. 
• Sellers step in near the right shoulder. 

In simple terms, the pattern shows a major change in market control. The trend that once moved strongly upward may now turn downward. 

How to Trade Using a Head and Shoulders Pattern? 

Upon learning the head and shoulders meaning, individuals may start trading with it. Trading the head and shoulders pattern requires patience and confirmation. Acting too early can lead to false signals. 

In practice, traders often follow these steps: 

• Wait for Neckline Break: Enter a short trade only after the price closes below the neckline. 
• Set Stop-Loss: Place the stop-loss above the right shoulder to manage risk. 
• Measure Target: The price target is usually calculated by measuring the distance from the head to the neckline and projecting it downward. 

Inverse Head and Shoulders Pattern 

The inverse head and shoulders pattern is simply the opposite version of the regular one. Instead of signalling a downward reversal, it signals a potential upward reversal. 

How it Forms 

• Appears after a downtrend. 
• Forms three troughs instead of peaks. 
• The middle trough (head) is lower than the two surrounding troughs (shoulders). 
• A neckline connects the highs between these troughs. 

How it Works 

• Sellers lose momentum after forming the head. 
• Buyers gradually regain strength. 

The head and shoulders candlestick pattern may appear in both regular and inverse forms. While it is not limited to candlesticks, it is commonly seen on candlestick charts used by traders today. 

Conclusion 

Head and shoulders patterns occur across all markets. It consists of a head, a left shoulder, and a right shoulder. The most common entry opportunity is a neckline breakout with a stop above (market peak) or below (market bottom) the right shoulder. When the pattern is added or subtracted, the profit is the difference between the breakout price and the low/high points. Although this strategy isn't perfect, it offers a structured approach to trading the markets based on reasoned price changes.