A Guide to Trading the Head and Shoulders Pattern

The head and shoulders pattern, as well as the inverse head and shoulders formation, are two of the most popular trading formations. Although they are not so easy to identify, they are very reliable and effective patterns that offer extremely lucrative risk-reward opportunities. 

In this blog post, we are looking at the structure of the head and shoulders and inverse head and shoulders patterns, how to correctly draw them on the chart  as well as their most effective use case. Moreover, we will be sharing tips on how to trade and make profit by trading the head and shoulders and inverse head and shoulders formations. 

Spotting the Head and Shoulders Pattern

The head and shoulders pattern is arguably the most popular reversal pattern among traders. It's called head and shoulders formation because it resembles a baseline with three peaks, with the center peak being the highest out of the three. As such, the three tops look like a ‘left shoulder’, ‘head’, and a ‘right shoulder’.

Both the traditional formation - head and shoulders - and the inverse head and shoulders formations are reversal patterns. Both consist of three mandatory elements:

1. Head - This is the highest (traditional formation) or the lowest (inverse version) peak of the formation. In both versions, the head should be at a higher/lower level compared to the two peaks on each of the sides. 

2. Shoulders - Two tops sitting on both sides of the center peak are called left and right shoulders. Ideally, they should be symmetrical i.e. at the same or near the same price level. As these are extremely difficult to identify, asymmetrical shoulders are also widely accepted, as long as the distance in two peaks is not huge. 

3. Neckline - A trend line that connects bottoms of the two shoulders is called a neckline. It's arguably the most important feature of the pattern as its break activates the pattern. 

The key difference between the traditional version and the inverse formation is that they occur at the opposite sides of the chart. A head and shoulders pattern is a bearish reversal pattern, which signals that the uptrend has peaked, and the reversal has started as the series of the higher highs (the first and second peak) is broken with the third peak, which is lower than the second.

As you can see in the picture above, the traditional formation starts in an uptrend and ends in a downtrend. As such, head and shoulders signals a top (the second peak) of the current uptrend. A break of the neckline activates the pattern and makes the entire setup tradeable. 

On the other hand, the inverse head and shoulders is a bullish reversal pattern that occurs at the end of a downtrend. The sellers have run out of gas as they were unable to continue the series of the lower lows. The third low (the right shoulder) is at a higher level than the previous peak. 

After the creation of a first peak (the left shoulder), the price action rebounds modestly before continuing lower to create a lower low (the head). The price then again rebounds to a level similar to where the first rebound was finished, creating a base for the neckline to be drawn. 

What follows is another pullback to create a third low (the right shoulder), before the price action finally bursts higher, breaking the neckline resistance, and activating the inverse head and shoulders pattern. 

Strengths and Weaknesses

Both versions of the pattern share the same strengths and weaknesses, as they only differ in the context of structure. Arguably, the greatest advantage of the head and shoulders pattern is that it defines clear areas to set risk levels and profit targets. 

Due to its design, the pattern offers a clearly defined stop loss, take profit, and entry levels. A trader should only follow the set of rules (described below) and make sure that they don’t “jump the gun” and enter a trade before the neckline is broken. 

It's extremely important to stress that both the inverse and the traditional head and shoulders patterns only occur at the bottom of an uptrend or downtrend. This is a common mistake traders and analysts make. It doesn’t matter that you drew a perfect head and shoulders pattern, if there is no prior uptrend or downtrend as both versions are reversal patterns. 

The key limitation of the head and shoulders pattern is that a strong trend sometimes causes the price action to continue in the same direction despite the third peak/low being a lower high or higher bottom. In this case, the head and shoulders, or inverse head and shoulders, are seen as continuation patterns as the prevailing trend has resumed after taking a short break.

Drawing the Pattern

Unlike some other chart patterns, trading the success of the head and shoulder formation rests very much on how well you draw the initial pattern. As outlined earlier, this pattern offers a set of predefined levels, as you are actually trading against the neckline. Thus, drawing the pattern and identifying three key elements is the crucial part of the entire trading process. 

The daily chart of USD/CAD shows a head and shoulders pattern that helps reverse the direction of a trend. The price action pushes higher, creating three consecutive peaks with the right shoulder slightly lower than the left shoulder. Still, there are two clear peaks on each side of the center peak, with a slightly ascending trend line connecting two shoulders. 

You can see that we started in an aggressive uptrend and finished the pattern in a downtrend, with the bears ultimately erasing more than half of the earlier gains. A similar situation occurs with the inverse head and shoulders pattern lower.

This is a NZD/USD daily chart where the sellers are pressing the price lower, creating a series of lows. The head is represented by a series of similar lows, while the two shoulders are sitting on each side of the head. Although the head usually consists of a single peak/low, we can also have rounded lows or peaks, as long as there are shoulders visible on each side of the head.

You can see that the NZD/USD pair creates a new short term low (the lowest low of the head) before pushing higher to create a series of the higher lows before eventually surging higher above the neckline. 

Trading the Head and Shoulders Pattern

We stated earlier that possibly the greatest advantage of this formation is that it offers precisely defined levels. The key is a neckline due to the three reasons:

1. A break of the neckline activates the pattern. Before the neckline is broken, we consider the pattern to still be in the making. 
2. A neckline defines the stop loss i.e. after the breakout, any reverse move to the other side of the neckline activates the stop loss and automatically invalidates the pattern. 
3. A distance between the neckline and the head is measured to calculate the take profit. 

We will now use the same two examples to give you a step-by-step guide on how to trade the head and shoulders and inverse head and shoulders patterns.

Once we have drawn the pattern and identified three key elements of the formation, we monitor the “draft” pattern closely and wait for the bears to potentially break the neckline and activate the formation. There are two options for the head and shoulders pattern as far as the entry is concerned. 

The first option offers you a chance to enter a short trade as soon as the neckline is broken and the daily candle closes below the broken neckline. This option means that you can’t miss a trade. 

However, this one is also riskier as this move lower can easily prove to be a failed breakdown. In this case, your stop-loss would be activated almost instantly. 

The second option is prefered by the majority of the trading community. It's based on an idea that you should make an entry after the price action closes below the neckline and the breakdown is confirmed. Accordingly, the buyers will then push the price action to retest the neckline, the so-called “throwback”, before resuming lower.

Thus, you should place the entry when the throwback occurs. Of course, the price action can still return above the neckline, however, the chances are smaller than with the first option. The limitation of the second option is that the price action can simply resume lower without performing a throwback i.e. a retest of the neckline is not guaranteed (see example 2 lower).

USD/CAD closed below the neckline on a daily basis, then the buyers pushed the price higher the next day, before ultimately sliding lower. From the risk-reward perspective, this is a perfect scenario as you are given the opportunity to enter a trade on the retest. 

Wherever you decided to place the entry, the stop-loss should be located above the neckline. You are advised to always allow for a cushion between the stop-loss and a neckline. As you can see in our example, the buyers were able to trade briefly above the neckline before getting rejected. 

The take profit is calculated by measuring the distance between the head and a neckline (the green line), and then copy-pasting the same trend line starting from the neckline and extending lower. This way, you define the exact point at which the head and shoulders pattern should be completed. 

Finally, our entry is at $1.2820, stop loss around $1.2860, while a take profit order is set at $1.2550. Hence, we risked 40 pips to make 270 pips, which is a phenomenal risk-reward ratio and the best evidence as to why the head and shoulders is such an effective reversal pattern. 

We now move to our second example by explaining how to trade the inverse head and shoulders. In essence, we follow the same set of rules. Once we have drawn all the key elements, we are waiting for the NZD bulls to push the price higher.

Earlier we discussed two options available to set your entry. This example belongs to the second option and it perfectly shows why this is a riskier option. As you can see, the bulls never returned to retest the broken neckline once the breakout occured. Hence, if you had opted to wait for a retest, you’d have missed the trade. 

By choosing the first option, you’d enter a trade once the daily close above the neckline has been secured. The stop loss is again placed below the neckline, while the blue line measures the distance for a take profit order. A few weeks later, the inverse head and shoulders pattern is completed. In this case, we risked 70 pips to gain around 200 pips, which makes a nearly 1:3 risk-reward ratio, meaning this was a very good setup from the risk tolerance perspective.