HEAD AND SHOULDERS PATTERN
Another very popular pattern is the Head and Shoulders Pattern, I think you can probably guess how it got its name.
This pattern starts off by creating a left shoulder where it reaches a new high but then retraces to make a new higher low. The head is then formed in the same way as the shoulder and retraces; followed by one more attempt to push higher but failing and price starts to fall. The neckline in this example is shown as a red dotted line, you then sell the break of neckline.
The Neckline
The pattern consists of 4 parts: left shoulder, right shoulder, a head and a neckline. The pattern is confirmed when the neckline is broken after the formation of the right shoulder. The head and shoulders (or peaks) are strong levels of resistance, and the neckline is the support.
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If we describe price action here, you can see that we were making new higher highs and higher lows but with the right shoulder we start to lose momentum and start a downtrend making lower highs and lower lows, which is why we sell the area of support (neckline/trendline) as price falls.
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In these examples the neckline is a diagonal line but it works exactly the same as if it was horizontal. It’s still a level of support, and once it’s been broken the sell trade is now valid.
This is an example of where you would enter short; which is the break of the trendline/neckline. You set your target by measuring the distance from the neckline to the head of the pattern; then place this dotted blue line at the break of the trendline/neckline and your target is the end of the dotted blue line.
Below is an example of how the Head and Shoulders Pattern may play out when price returns to retest the neckline before then falling further.
A breakout, retest and continuation would give a solid indication to enter the trade short. If you entered short(sell trade) at the break and close you would have placed your stops above the last higher low (which would be the right shoulder)so you would still profit from this trade.
This is an example of a more conservative approach to trading the Head and Shoulders Pattern.
In this method we wait for the break and candlestick close past the trendline/neckline and then we sell. You just need to place your stop loss appropriately and work out the risk reward ratio, which in this case is 1:2 which is good. When placing your stop loss, make sure it’s well above the neckline as it’s very possible that price retests this area before dropping further.
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If your stops are too close you will be stopped out and watch price fall back the way you thought it would.
Inverse Head and Shoulders Pattern
The inverse head and shoulders pattern is simply the opposite to the normal head and shoulders pattern.
The formation occurs when price initially falls to make a new low and rallies after. It repeats this to make another new low and rallies again creating the head. The next attempt to make a new low fails and price reverses up to the neckline. A break of this neckline indicates a change in direction and the long trade setup is valid.