Head and Shoulders Stock Pattern: Trading Strategy Guide

When it comes to technical analysis, the head and shoulders stock pattern stands as a distinctive and widely recognised chart formation. This pattern serves as a powerful indicator, offering insights into potential trend reversals and signalling lucrative trading opportunities. Read on to learn about the intricacies of the head and shoulders pattern, exploring its formation, interpretation, and the strategic approaches it offers to traders in stock markets. Whether you’re a novice seeking to enhance your understanding of technical analysis or an experienced trader looking to refine your strategies, this guide aims to equip you with the knowledge needed to navigate the complexities of the head and shoulders stock pattern.

​​Meaning of Head and Shoulders Stock Pattern

In technical analysis, a head and shoulders pattern is highly employed. It’s a unique chart pattern that signals a change in trend from bullish to bearish. There are three parts to a head-and-shoulders pattern.

• After a protracted bullish trend, the price climbs high before falling to create a trough.
• The price increases a second time, much beyond the first high, and then declines again.
• The price increases again, but only to the initial peak before falling.
• The shoulders are formed by the first and third peaks, while the head comprises the second peak.
• The neckline is the line that divides the first and second troughs.

In the opinion of most traders, one of the most reliable trend reversal patterns is the head and shoulders chart pattern. It predicts when an upward trend is about to finish. Textbook head and shoulder patterns are rare, but most traders think they signal a significant trend reversal when they appear. A typical head and shoulders formation is seen as a bearish setup.

Head and Shoulders Inverse Pattern     

A reversal pattern in stock trading is the inverse head and shoulders pattern. Its visual depiction on the chart, which consists of two higher lows on either side of a lower peak in price movement in the centre, gives rise to its name.

• The inverse head and shoulders pattern often closes off a downward price trend on a chart.
• The trader can see the first shoulder forming and the downward momentum diminishing when the price action breaches the left shoulder and descends further.
• In the end, there’s a rebound followed by a retest of the right shoulder lows, which should not result in a lower low. When prices change direction after a break and move back to the breakout level to determine whether it will hold, it is referred to as a retest.

Using Head and Shoulders Stock Pattern to Trade

• Traders often apply the head and shoulders pattern in various trading scenarios.
• The most effective strategies involve following trends, and considering the pattern’s nature as a trend reversal indicator.
• Traders recognise the head and shoulders pattern as specifically signalling a reversal. However, these reversals may be short-lived, especially in the presence of a robust daily trend.
• Strong trends are challenging to reverse, often experiencing only brief pauses akin to short breaks during a challenging ascent. Similar to riding a bicycle uphill, the price may need brief stops before continuing its climb during strong daily trends. Robust trends might involve larger pauses, but these are often followed by the price resuming its upward pattern.
• Traders seek to capitalise on profit opportunities during these pauses while remaining vigilant for potential trend changes.

Head and Shoulders Breakout

A head and shoulders pattern breakout does not necessarily lead to a sudden downward trend. As the example above shows, prices occasionally tend to retest the neckline, which then acts as a resistance level. Remember that the neckline should not be seen as a simple line but as a price-level area. This is a result of the volatility that each instrument possesses. Price levels don’t always function exactly as they should. Therefore, it’s okay to let some price volatility drive the signals.

Breakout Styles for Head and Shoulders Patterns

• Breakout of the Head and Shoulders Pattern Upon Retest: Prices retest the neckline after a successful breakout from the neckline before finally advancing in the direction of the breakout.
• Entry: We cannot predict whether the price will return to the neckline so that we can enter the neckline breakout itself. Nevertheless, the beginning amount should be 50% of the trade’s intended quantity for risk management reasons.
• Stop Loss: Use 1 average true range (ATR) above the resistance at the neckline as a stop loss.
• Add to Position: After the retest is finished and the trader notices that prices are decreasing following the retest, add the remaining 50% of the quantity to the position.

Breakout of the Head and Shoulders Pattern Without a Retest

Sometimes, the prices of a stock might penetrate the neckline and drop further due to intense selling pressure.

• Entry: Place trade when a big bearish candle signals a breakout (check volume to confirm the momentum). Now, fill only 50% of the initial quantity of the trade according to risk management procedures.
• Stop Loss: Place the stop loss at one average true range (ATR) above the neck. ATR shows the average price variation for a particular time period.
• Add to Position: The remaining 50% of the quantity can be added after 4-5 candles if there is no indication of a retracement or negative momentum.

Breakout Head and Shoulders Design with  Flag or Pennant

Before a breakout, seeing a flag or pennant around the neckline is highly typical., trading the head and shoulders pattern is a wise move.

• Entry: Place the trade once the flag breakout near the neckline has been verified. We may trade in full quantity at this signal since the flag breakout acts as a secondary confirmation, and it is a smart risk management strategy because the flag breakout makes it simpler to handle the stop loss.
• Stop Loss: Place it slightly above the flag chart pattern’s upper border.

Advantages and Disadvantages of the Head and Shoulders Stock Pattern

Advantages of Head and Shoulders Stock Pattern

• It is one of the best indicators for foretelling a trend reversal. As a result, there is very little chance of inaccuracy if the trader sees it on the trader. 
• Using head and shoulders technical analysis, traders may reasonably forecast the degree of a decline in an asset’s value following the pattern’s final development. It is determined by measuring from the neck’s base to the top of the head. The price will decrease roughly by the same amount after breaking through the neckline.
• Three dips in the bullish head and shoulders pattern indicate that the trending battle is still ongoing and that traders should not hurry to buy currencies at this time. Like that, one should anticipate an initial fall and then a rise in the asset price after hitting the top values on the direct head and shoulders pattern.

Disadvantages of Head and Shoulders Stock Pattern

• Given that the long term rising trend might reappear as soon as price movement hits the neckline, there is a chance of getting a misleading signal to sell the currency. Yet, the model will provide an accurate signal 85% of the time.
• A trader may miss a chance to open an order because the pattern takes time to materialise. This occurs when a trader anticipates seeing a head and shoulders pattern appear on a currency or stock chart, but it ultimately does not.

Conclusion

The head and shoulders stock pattern proves to be a valuable tool for traders, providing insights into potential trend reversals and strategic opportunities. This guide has highlighted its effectiveness in trend-following scenarios. Traders recognise it as a reversal indicator but also acknowledge the transient nature of reversals in the face of strong daily trends. Similar to navigating challenging terrain, traders capitalise on pattern pauses for profit, remaining watchful for potential trend shifts. Incorporating the insights from this guide enhances traders’ ability to navigate the dynamic stock market landscape with the Head and Shoulders pattern as a guiding strategy.

Frequently Asked Questions (FAQs)