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:
- A break of the neckline activates the pattern. Before the neckline is broken, we consider the pattern to still be in the making.
- 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.
- 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.