Head and Shoulders Pattern

Head and Shoulders Pattern

Table of Contents

The Head and shoulders pattern is a type of trend reversal pattern. It consists of a new high, a reversion, a rebound to make the new high price higher, and that bounces again to form a lower high price before dropping again that is reversion. The neckline, also known as the support trend line, is established by connecting the two lows of the bounce points. 

The initial shoulder and head are the first high and following higher high. The second shoulder is the peak of the second bounce. The head and shoulders pattern is triggered when the price falls through the support trend line. When the support trend line is broken, a new downtrend starts, and this pattern forms when the buyers are exhausted and lose interest.

Introduction 

The head and shoulders chart pattern is a negative reversal formation on the candlestick chart that can spot a trend reversal after it has concluded. While the bullish setting is an inverse head and shoulders, the bearish setup is inverse. They commonly appear in the shape of a baseline with three peaks on a graph. This pattern usually occurs near the end of an upswing and indicates that it will reverse.

You might be curious as to how this pattern earned its name. It’s not because of the well-known shampoo brand; in fact, the design resembles a head and two shoulders (left and right shoulders). It indicates a baseline with three tops, the centre of which is higher than the other two, which should all be on the same line. The neckline responsible for initiating the bearish signal is that baseline. 

So, if the price falls below it, we have the option to sell. It indicates a baseline with three tops, the centre of which is higher than the other two, which should all be on the same line. The neckline responsible for initiating the bearish signal is that baseline. So, if the price falls below it, we have the option to sell.

The head and shoulders design and other variations such as double tops, bottoms, and triangles are among the most popular chart patterns. Traders consider this pattern one of the most dependable, as it generates firm indications. Combining it with a technical analysis indicator, mainly an oscillator that shows the overbought level makes the pattern even more meaningful.

Identification of Head and Shoulders Pattern 

It’s critical to recognise the head and shoulders pattern correctly. You can end yourself trading against the prevailing trend if you don’t. This pattern contains elements like Left Shoulder, Head, Right Shoulder, and Neckline that trigger the bearish signal. It’s crucial to remember that the neckline isn’t necessarily straight. In reality, it will most likely be skewed in one direction or the other. However, the signal is usually more reliable if the slope is down.

Different Components of Head and Shoulders Pattern 

The Head and Shoulders pattern has various characteristics that distinguish it from other designs on the chart. Understanding its components is critical, so you don’t mix it with different chart patterns. For example, it may be interpreted when a peak shoulder forms first, then a higher peak or head, and finally a lower peak or tail shoulder. When the double lowest points of the two troughs are joined, the neckline appears.

Left Shoulder

After encountering some resistance, the uptrend forms a high and then pulls back for a period. Then, it bounces back to the likely continuing upswing after finding some support. So, while we can’t see it in real-time, this is how the left shoulder gets produced. For example, the price action could appear to be building a double top.

Prior Trend

The first thing to analyse is the previous trend, which should be bullish in most cases. The longer an upswing lasts, the greater the chance of a significant reversal that bears can profit from. Unfortunately, the upswing that led to the head and shoulders pattern is beginning to show indications of weakness, as the bulls are unable to maintain it.

Neckline

We’ve already defined the neckline, but now is the time to use it to distinguish bulls from bears. To put it another way, if the price breaks below this support line, we can open a short trade with great conviction. 

Right Shoulder 

The price finds firm support in the neckline zone on the second pullback and then has one last chance to extend the rise. However, bulls give up after encountering resistance at the same level as the first high, and the price retreats for the third time. This lengthy process indicates that the bullish trend has reached its limit. The third high represents the right shoulder. The left and right shoulders should preferably be at about the same level, but the pattern will still be useful even if they aren’t.

Head 

The price breaks the previous high during the rebound after the left shoulder but runs into a fresh obstacle. Bulls can’t make it despite the momentary surge, and the price is coming back for a second time, leaving the higher high behind. The top of the head and shoulders pattern is generated at this point. 

On the other hand, the second pullback comes to a close to the same level as the first support, here is where the neckline begins to develop. We have the left shoulder and the pattern’s head at this time. 

How to trade Head and Shoulders?

When you’ve identified the pattern, start hunting for the signal you’ll need to join the market. For example, this is a signal when the neckline breaks through the price. A short position for head and shoulders tops should be open and long for head and shoulders bottoms when the neckline is broken. The pattern’s depth determines the price goal as a rule of thumb. 

Failure of Head and Shoulders Pattern

Although head and shoulders are one of the most reliable chart patterns for equities trading, it can fail just like any other chart approach. When we obtain our confirmation signal, the price does not always meet our minimal aim. In other circumstances, the price will break the neckline, confirming the formation, and we will observe no movement in our favour. Unfortunately, these are not uncommon occurrences.  

Even if the head and shoulders pattern proceeds as planned, with a decisive breakthrough in the neckline, it may later ‘fail,’ that is, not complete the trend change. The first symptom of this is if the price goes back over the neckline – this should not happen once the neckline has been broken, and it indicates that the trend reversal is not as strong as it appears to be. Occasionally, the original pattern will reappear. 

This relates to what was said before. Don’t expect precision when reading technical analysis signals, it will drive you insane. Instead, make sure you understand the indicators well enough to grasp what they indicate on the balance of probabilities, trade accordingly, and don’t lose sleep over losing deals. 

The best method to deal with them is to close the transaction as soon as you realise it isn’t working out. Then, you will be able to spot the indications and, if necessary, reduce your losses swiftly due to what you are learning. 

Inverse Head and Shoulders

When a downtrend turns into an upswing, the inverse head and shoulders pattern emerges, essentially the head and shoulders pattern we just discussed reversed upside down. As a result, it’s only a gradual shift in the trend’s direction, as seen by a broken trendline and a weakening of the current trend. Trading volume is crucial in validating the pattern as an efficient inverse head and shoulders. 

While volume is less relevant during negative price changes, it is critical when a strong trend is heading up. When the neckline price breaks, the volume should expand as it rises from the head and maybe much stronger. The last bull rise must also show strong volume strength to validate the power of the price’s new direction. 

Volume is more crucial with this pattern than with the head and shoulders topping pattern. When the price is falling, you don’t have to be concerned about volume because the price can fail without any market action due to a lack of interest or demand. On the other hand, when prices climb, the volume must be high for the price to rise, indicating that buyers are pushing the price up. In other words, it’s a genuine and well-supported initiative. 

Complex Head and Shoulders

Of course, nothing is simple in life, especially in trading, and you will not always get a perfect copybook head and shoulders pattern. The ‘Complex Head and Shoulders Pattern,’ a more intricate variant with added pieces, is one variation you can locate. The extra details include a double head or a double shoulder – in other words, and the tendency is taking longer to change direction. 

This pattern has the same forecasting abilities as the standard pattern, and you can figure out why by applying the same ideas. Unfortunately, this isn’t one of things that happens very often.

Price Target 

Cryptocurrency traders would go short if the price fell below the neckline. The distance between the neckline and the top of the head determines the price target of the sell order. As a result, you can subtract the length from the breakout price to produce an approximate price objective after calculating the distance. Other elements, such as past support levels before the pattern, long-term moving averages, and Fibonacci retracement levels, can influence the goal.

Bottomline 

The head and shoulders pattern is one of the best, famous and profitable patterns. However, still, there are chances of failure of the pattern, so you should be ready for it and, especially since cryptocurrencies are highly volatile and unpredictable, given that. While the pattern might be subjective at times, it includes entries, stops, and profit objectives, making it simple to adopt a trading strategy. A left shoulder, head, and right shoulder make up the pattern. 

You can trade with a leading and highly regulated broker Investby using the head and shoulder patterns. 

While this may not be ideal for everyone, it is worth noting that these formations can vary greatly. Not all head and shoulders formations are created equal, and it’s important to remember that the profitability of these trades is dependent on the ratio of shoulder to head size.

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