The head and shoulders pattern is a price action trading strategy that works by recognizing reversal patterns in the financial markets. It can help you spot market tops and bottoms, thereby predict a bull-to-bear trend reversal.
The head and shoulders pattern is one of the crucial parts of any trader’s arsenal that helps them anticipate price trends in the financial market and make trading decisions accordingly.
The chart formation has three peaks. The first and the third peaks are somewhat similar in height, while the second peak is the highest one. The pattern documents the possible end of the upward trend or bull market and the beginning of a downward trend or bear market.
What Does Head and Shoulders Pattern Indicate?
The head and shoulders pattern starts forming when the price of an instrument rises and then falls back to the same level, creating one spike. The price then rises and falls back again to the same base level; this second spike is higher than the previous one. The price rises and falls again to the same base level; this creates a third and final spike, which is smaller than the previous one and similar to the first spike. The first and third spikes are the shoulders, and the second spike – the highest one – is called the head. The line that connects the low of the head and shoulder is called the neckline.
The first peak and subsequent decline underline the slowing bull run. The second peak, where the line touches a newer height, shows the bull’s resistance against a downward trend. Here, the bull may bounce back and continues its run if provided with a favorable condition. If not, if the price falls again for the second time, it’s a sign of bears getting stronger. The bulls will make another attempt, but the peak this time is less than the previous high. This failure to accelerate the upward price movement shows the end of the bulls’ run. It means there’s a bull-to-bear reversal, and bears are about to take over the market. The prices are about to go down.
How to Trade the Head and Shoulders Pattern?
Trading head and shoulders pattern requires logical trading instinct. The entry point for the traders is the breakout of the neckline. The exit point is when the price has peaked in the second spike. The difference between the market high and the market bottom is your profit margin. Admittedly, identifying the onset of this pattern at an early point and setting your take-profit marks can be a challenge for beginners. But with experience, you can get more proficient in recognizing chart patterns and capitalising on those patterns.
Inverse Head and Shoulders
Inverse head and shoulders pattern is the exact opposite of head and shoulder pattern. It indicates a bear-to-bull trend reversal. The pattern starts with a fall in price and rise. The price falls and rises again; this second time, the fall is bigger than the previous low. The price falls for the final time, touching a similar low as the first time, before starting its upward trend. The final jump indicates a bull market.
