Head and Shoulders Reversal Pattern

Head and shoulders is a bearish reversal pattern that often forms at the end of a bullish trend or a short term swing. It also predicts a possible downturn in price if the pattern is validated. This technical structure is probably the most famous one among technical traders, because when validated it is usually followed by mega bearish trend. Like any other pattern it has its specific characteristics, rules for trading as well as filters that might negate the pattern.

The structure

The pattern consists of three consecutive peaks: left shoulder, the head (it is the highest peak), and the right shoulder. Some technicians say that it is better when the shoulders are relatively the same in size and form in the same length of time, but even if that is not the case most of these patterns work out pretty well.

In an uptrend the left shoulder forms first. When this point is reached, price sharply reverses and starts going down (usually quite dramatically). After some time price stops falling, consolidates and makes another rally upwards by exceeding previous high (left shoulder) and forms the head of the pattern. After some consolidation price starts going down again and reaches relatively the same area as in the first case when it went down from the first peak. It finds support again and makes another attempt to reach previous high (the head), but fails. That’s the level where the right shoulder forms. Price consolidates the last time and starts falling like in previous times.

Now, if you draw a trendline from the low of the first decline through the low of the decline from the head you will get a neck line. The neckline acts as key support level of the pattern. If broken downwards, the pattern is validated and the downtrend confirmed.

How to trade head and shoulders

Trading rules are really simple. A trader has to place a sell stop order below the neckline (some 5 or 10 pips) and when price reaches the level the order is automatically opened. The reason for placing the order at that spot is obvious: price gathers momentum when falling down and a lot of traders expect the momentum to continue when the neckline is broken. In most cases that’s precisely what happens.

The general rule for placing stop loss is putting it above the right shoulder (some 5 or 10 pips). Why? Because, if price breaks the neckline and then comes back and goes above the right shoulder, the pattern is invalidated.

Take profit

The minimum take profit zone is calculated by measuring the distance from the top of the head to the neckline. When breakout occurs that is the minimum distance we expect price to go down. Of course, in most cases it will go further, but you can always lock in some profits by doing these calculations.

In the example below you can see usd/cad pair that was in a prolonged trend for a number of years. However, in 2001 it started showing signs of exhaustion. In a matter of two years it formed a head and shoulders pattern and the uptrend was finished when price broke through the neckline on the last week of February, 2003. In this case minimum target was 1100 pips. The level was reached in a matter of a few months, while price continued falling for the next four years till 2007. It collapsed more than 6000 pips. Wow!

usdcad head and shoulders