Head and Shoulders pattern is one of the most known and used patterns from all the price action methods / patterns used in trading. Head and Shoulders pattern is also one of the oldest patterns used for centuries in trading, even when there was no computers and traders drew their charts manually (yes, believe it or not, there was a time when traders actually drew their charts manually).
The Head And Shoulders Pattern Structure
Head And Shoulders Pattern is one of the most important patterns from all the existing reversal patterns. It can be observed either an up trend or a downtrend (case in which we call it inverted Head and Shoulders pattern). It consists of three heights (or lows for inverted head and shoulders pattern), the middle one being the highest. It also has a neckline, which is a trend line which links the lows (the heights for inverted head and shoulders pattern) created during the formation of this pattern.
Here is a Head and Shoulders pattern (aslo called SHS pattern – Shoulder Head Shoulder) formed on GOLD chart on H1 (one hour) timeframe:
How Head And Shoulders pattern (SHS pattern) is formed
After a strong thrust (impulse), the price reaches a level of resistance (for SHS pattern) or support (for an inverted SHS pattern). Then we see a price movement which will retest the previous support (for SHS pattern) or resistance (for an inverted SHS pattern), this is the moment when the price created the head. This is also the first retest of the neckline.
After that, there will be an attempt to resume the original thrust (impulse) that fails – the price is not able to reach a new high and this is the moment when is created the second shoulder. This causes the closure of long positions and the appearance of the sellers.
The next price movement is another retest of the neckline. The neckline is the support line joining the lows formed between the left and right shoulder and the head. Breaking this line confirms the Head And Shoulders pattern. If we analyze SHS pattern for a down trend, then the neck line will be a line of resistance that joins the heights formed between the left and right shoulder and the head.
Characteristic of Head And Shoulders pattern
- The Head And Shoulders pattern must be similar to the head and shoulder of a person, be proportionate, without large deviations from the form.
- Both shoulders should be well-formed. A shoulder should not be much larger than another and their heights should be approximately the same;
- The pattern appears at the end of a strong trend;
- The pattern must be proportional to the previous movement;
- The neck of the pattern doesn’t need to have a big slope. The closer it is to the horizontal, the more important the figure is;
- Breaking the neckline completes the figure, and the return of the price at the level of this test line represents a signal specific for the transaction;
- The target for profit is the projection of the distance between the heightest / lowest point of the head and the neckline, drawn from the breaking point in the direction of the penetration.
- The Stop Loss order is placed above / below the height / low of the last shoulder;
How to trade the Head And Shoulders pattern using AB=CD Pattern
Let’s take a closer look at the Head And Shoulders pattern formed on GOLD from our earlier example:
The biggest advantage of this way of trading is that instead we open our position at the breaking of the neckline, we are already into a position which means that we made some profits and we are in a “free ride” position.
After we opened our trade we need to place a Fibonacci Retracement on the AD swing so we can follow it’s levels in order to secure profits.
Now, because we are already into a position and we already made some profits, we can add another position to our opened trade at the breaking of the trendline keeping the same stop loss from our initial opened trade.
We secure profits in the same way I explained into the AB=CD pattern article at all Fibonacci Retracement levels. Also, we move our stop loss to the previous Fibonacci Retracement level as the price reaches the next levels (for example, after the price reaches 50.0 Fibonacci Retracement level we move our SL few pips above 38.2 level, and so on).
We have also a synergy between an AB=CD pattern and SHS pattern because in both cases the main target is the 61.8 Fibonacci Retracement level.
Don’t forget to use a proper risk and money management and check for every trade opportunity the SL size and if there is an acceptable loss. If there is an unacceptable loss the trader will simply skip the trade and move to the next one. It is recommended to use a risk of maximum 2% to 5% of equity.