Multiple Ways to Trade the Head and Shoulders Chart Pattern

By:

James Knight

James is a lead editor for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets. His ... read more.

Updated: Sep 26, 2022

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Learn the pros and cons of the head and shoulders chart pattern, how it can be used for analysis and some different ways to trade it. Also, learn more about the investment world and not-often-discussed head and shoulders continuation pattern.

What is the Head and Shoulders Chart Pattern?

Price is the ultimate indicator. It always shows when a reversal is under way. A reversal is a transition from an uptrend to a downtrend, or vice versa. While price always eventually reveals the reversal, there are patterns that highlight when it is starting. The head and shoulders pattern is one of those patterns. The pattern itself actually represents the transitions from uptrend to downtrend (and an inverse head and shoulders pattern shows the transition from downtrend to uptrend).

Head and shoulders chart patterns occur in all markets, and on all time frames. Here’s what it looks like, how it is interpreted and ultimately how it can be traded. The “usual” way to trade it is discussed, as well as some alternate ways. I am not a big fan of the “text book” way to trade it, because if we really understand the pattern then there are some better entry points we can look for. That said, the head and shoulders doesn’t need to be traded, but it is a good pattern to know since it alerts us whether we should be changing our view on the market (favoring longs before the pattern, and favoring shorts after the pattern, or vice versa for an inverse pattern).

How to Interpret the Head and Shoulders Chart Pattern

The head and shoulders pattern signals a reversal because it shows an uptrend is likely over. The pattern is created by the price rallying into a first high (left shoulder), then pulling back (left armpit), rallying to a new high (head), pulling back (right armpit), rallying to a lower high than the head (right shoulder) and the proceeding to drop again. Here’s what it looks like on a chart.

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A trendline connects the left armpit low to the right armpit low, forming a neckline. After the right shoulder has formed, if the price drops below the neckline the pattern is considered complete, and a reversal is underway. Occasionally the neckline won’t be of use, because it is angled too steeply (either up or down) to provide a viable signal. When this occur, use the right armpit low as an alternative. If the price drops below the neckline, or the right armpit low, consider the pattern complete. By “complete” I mean that the reversal is in place, indicating that a downtrend is underway and the price is likely to head lower, overall (opposite for an inverse pattern).

Waiting for the pattern complete indicates that a trend reversal is already underway. But we can actually see evidence of a reversal earlier. This is especially true when the head and shoulders takes on a certain shape. For example, the right armpit may be lower than the left. When this occurs the price has already created a lower low (right armpit is below left armpit). A lower swing low is a sign of a downtrend, not an uptrend. So if the price makes a lower low, and then rallies and makes a lower high (right shoulder)–and then starts dropping again–we have two key pieces of evidence that a downtrend is underway (lower high and lower low). We have this evidence before the pattern completes. Once the patterns completes, or the price drops below the right armpit, we have even more evidence that the downtrend is underway…or at minimum that the uptrend is in trouble and we should stay away from buying for the time being. We will talk more about buying and selling based on this pattern a bit later.

Understanding what the pattern is telling us

The key is not to think about the pattern specifically. Understand what the pattern is telling us. People have a tendency to get very caught up in a how a pattern looks, but that is not the important part. What we are really watching is that transition from uptrend to downtrend. Since uptrends make overall higher swing lows and higher swing highs, when we start to see lower swing highs and lows, that tells us the trend is in trouble. The head and shoulders pattern is simply a way to visualize that transition.

If the right armpit is higher than the left armpit, then we need to wait for pattern to complete, because in this case we don’t have a lower swing low during the pattern. The right shoulder will form a lower swing high, but until the price starts dropping again it is a bit pre-mature to start calling it a downtrend. Notice the difference? If the right armpit is below the left, and then forms the right shoulder, we have both a lower swing high and a lower swing low. But if the right armpit is above the left armpit, then we only have the lower swing high on the right shoulder to tell us the downtrend is starting…in others words, there is less evidence in this case so we may want to wait for the pattern to complete before considering it a downtrend.

Here is an example of the right armpit being lower than the left armpit. By connecting all the swing highs and lows with lines we can see the uptrend, and also the transition to the downtrend. When you are starting out in trading, this is a good exercise to do because it highlights the changing trajectory of the price very well. On this type of pattern we have a lot of evidence of a reversal before the pattern completes. As the price is moving down toward the completion point the price has already made a lower swing low and lower swing high. As we will discuss later, having that knowledge a bit earlier than most other people (who are just focused on the pattern, and not really understanding what is happening while it is forming) will provide better entry points–and that means trades with smaller risk and greater profit potential.

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Ways to Trade the Pattern

First, let’s look at the textbook way to trade the head and shoulders pattern. While it is viable, it is not my favorite way to take advantage of this type of price movement.

Take a short trade when the head and shoulders chart pattern completes (price breaks below right armpit low or neckline). Place a stop loss order just above the right shoulder. Calculate a target for the trade by measuring the height of the pattern (high of the head to low of the armpit(s)), and subtracting it from the breakout price. In figure 1, take the difference between 0.8395, which is the head, and the low of the pattern at 0.8370, which is the low of the armpits, to get a height of 25 pips. Subtract this height from 0.8370, the breakout price, to get a target of 0.8345.

The risk of course is that price moves higher again, above the right shoulder, hitting the stop loss. One good thing about the head and shoulders is that the reward to risk is favorable. Since the profit target is based on the entire pattern, and the risk is based on the right shoulder, the profit potential is always greater than the risk.

Use a bit of common sense when trading the head and shoulders pattern. If there is a huge head and shoulders pattern due to some rare news event, then the profit target may not be reached since the volatility that created the head and shoulders is likely to dissipate. If we base profit targets on volatile and rare events, then we basically need another volatile and rare event to trigger a move big enough to reach our target.

Figure 2 had a high of 2.1161 and a right armpit low of 1.9337 (shown again in Fig. 3). A pretty big pattern: 1824 pips high. Remember, this is a weekly chart, and these patterns occur on all time frames. The armpit low is also the breakout point, so a short trade is entered when the price moves below that level. A profit target is placed at 1.9337-0.1824 = 1.7513. The stop loss is placed above the right shoulder. In this case, before the currency breaks lower the price actually forms two right shoulders. The stop loss goes just above the lower shoulder (S2), at approximately 2.02 (if we entered on the first shoulder, our stop loss would go above that, but could be dropped to just above S2 after it forms and the price starts dropping again). That is 863 pips of risk, but our reward potential is 1824 pips. So it doesn’t necessarily matter what time frame is being used, the important thing to remember is that we want our profit potential to outweigh our risk.

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The classic way to trade the head and shoulders pattern always provides an entry point, assuming the price drops below the right armpit or neckline.

The next way to trade the pattern won’t always provide a signal. The next way requires a few more things to occur. In other words, for trading purposes, I want the patterns I trade to go through a more thorough filtering process.

The way I like to trade the head and shoulders is to short sell as the left shoulder is forming. The stop loss is placed in the same position, and the target is also calculated the same.

The things that change are how and where we get in. Also, the right armpit must drop below the left armpit or be of similar level to the the left armpit (remember, this gives a bit of extra evidence of a reversal while the pattern is forming). For more on why this is, see Strong Trend Reversal Strategy.

Assuming the right armpit is below the left (or the two are at similar levels), as the price starts to rise into the right shoulder we can watch for a couple early entry signals. I like to watch for the price to consolidate (move sideways for several price bars), at a lower high than the head, and then enter a short trade when the price drops below the low of the consolidation. Alternatively, a bearish engulfing candlestick pattern can be used as an entry signal.

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Numbers are not even required to show the difference between the alternate method and the classic method. Our entry point in this case is way above the classic entry point. This means our entry is closer to our stop loss, which means our profit potential is going to be much bigger relative to the risk we are taking on.

The drawback of this strategy is that it takes more practice than the classic method. We have to be able to see the pattern forming before it is completes. We need to make the assessment of whether the trend is actually turning to the downside. Then, we need to be patient enough to wait for the consolidation and a breakout to the downside, or a bearish engulfing pattern (during the right shoulder). This is a more advanced trade.

Since this alternate method is more stringent, it doesn’t occur as often as the classic entry method. Although, the alternate method typically provides a way better reward:risk ratio, therefore it typically pays to be more stringent.

How to Trade the Inverse Head and Shoulders Chart Pattern

An inverse head and shoulders has the same structure as discussed above, except it is flipped upside down.

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The inverse pattern is traded in the same way. The traditional method is to buy when the price breaks above the neckline of the inverse pattern (or the right armpit high if the neckline is too angled to be relevant). Place a stop loss order below the right shoulder. Find the difference between the high and low of the pattern, and then add that distance to the breakout price to attain a target price for the trade.

Another option is to go long once the right shoulder makes a higher low than the head, and then starts moving higher again. I prefer this method when the left armpit is almost as high, or preferably higher, than the right armpit. I like to watch for a consolidation to form during the right shoulder, and then enter long when the price breaks above the consolidation high. Bullish engulfing patterns are also a viable entry signal. These alternative entries will result in a lower entry price than the neckline method, which results in a better reward:risk ratio.

In figure 5 we have a right armpit that almost reaches the left armpit (think about what that tells you about how the strength of selling has diminished). Then on the right shoulder, we have a strong upside (green) candle signaling the price is moving back up. It isn’t a perfect engulfing pattern, but it does show the strong transition back to the upside. This is a potential entry. The price also moved sideways for a period after that, so a long trade could have been taken when the price broke above that consolidation. Both these entry points would have gotten a trader in at a better price compared to waiting for the neckline breakout.

Use the same stop loss location and target estimate for both methods.

Head and Shoulders Continuation Pattern

Initially, I said that a head and shoulders is a reversal pattern, but not always the case. As with everything in trading, it depends on context.

What I have found is that reversal patterns are at least as large as the typical price wave in the trend that precedes it.

If the pattern looks very small compared to the price waves around it, it very well could be a continuation pattern. For example, if the trend is up (with big price waves to the upside) and then a small head and shoulders forms, it is actually quite likely the price could continue higher overall, instead of reversing.

Figures 1, 2, 3 and 4 all show head and shoulders that fit within the context of a reversal. Why? Because the down moves in the pattern are at least as big as some of the recent moves to the upside. One very important element to chart analysis is what I call velocity and magnitude. If you have big waves to the upside, and then small waves to the downside, that indicates that the trend is likely to continue higher. To reverse a trend, you need waves to the downside that are equal or greater in size than the up waves (notice how this relates to the alternate trading methods mentioned above?).

So if you have big up waves, and then a little head and shoulders chart pattern, there is no power in the pattern to reverse the trend (it may, on occasion, or temporarily, but until we get big down waves we must give respect to the uptrend and assume it is going to continue).

The same is true of downtrends. If we have strong waves down, and then a small head and shoulders forms, it is quite likely that the price could keep heading lower. The small pattern doesn’t show enough conviction on the part of the buyers to reverse the strong selling. As the pattern forms, it is more likely to eventually give way to more selling.

Here is an example of an inverse head and shoulders continuation pattern. The price is dropping aggressively. The entire pattern is only about half the size of the last drop. The price forms the inverse head and shoulders (many people would think this would point to a reversal back to the upside), but the price stalls and then plummets again.

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There are no definitive rules for determining whether a head and shoulders is a continuation pattern or a reversal pattern. But in my experience, continuation patterns appear small relative to the price moves around them. The entire continuation pattern is more of just a sideways period where the market takes a bit of a rest from the current trend, but then the trend continues. A reversal pattern is larger and more forceful. It shows an overall transition before uptrend to downtrend, or vice versa. Focus on the size of the waves in the pattern compared to the size of the waves in the trend preceding it.

How to trade a continuation pattern? In figure 6 we can see strong downward movement heading into the pattern. The price forms the inverse head and shoulders, tries to go up, but quickly fails. There are multiple ways to get into this trade. One way would be to enter short when the price drops below the right shoulder low. A stop loss goes above the recent swing high. We are expecting the price to drop, and it will likely drop by the size of the pattern (or more). So take the height to the pattern, deduct it from the low and that gives an approximate profit target.

Same thing if the trend is up. In this case, we have strong upward movement into a small head and shoulders. If the price starts rallying above armpits or shoulders, BUY, and place a stop loss below the recent swing low. I say armpits or shoulders, because you could have an inverse or normal continuation head and shoulders patterns in both uptrends and/or downtrends.

Final Words

The head and shoulders chart pattern is one of the most popular chart patterns around. It’s easy to spot, but is really just showing a transition from an uptrend to a downtrend. Understanding the transition–the higher highs on the left side of the pattern to lower highs on the right side of the pattern–is the key take away here. Trade the head and shoulders in the traditional way, waiting for a break below the neckline, or trade it using the alternate approach. The alternate approach requires more experience at reading trends, and requires an entry once the price forms the right shoulder and then begins to drop again. Practice spotting these patterns and then test out which entry method works better for you in a demo account.

Inverse head and shoulders are traded in a similar way, except occur after a market decline, and indicate the trend is turning higher. All chart patterns are fallible and losing trades will occur, this is why a stop loss is used on all positions.

Continuations occur within a trend, and indicate a continuation instead of a reversal. I have found that continuation patterns are smaller relative to the price waves around them.