In forex trading, a “head and shoulders” is known as the trend reversal pattern. Traders use this particular chart pattern to explore the big picture of the market conditions which help them to identify the trade signals.
Although, being able to spot the pattern correctly on the live charts plays the most important part. In this article, we’ll briefly discuss the head and shoulders pattern along with some chart examples.
The Head and Shoulders Pattern
The first peak of the chart is the first shoulder, then comes the highest peak as the head, and finally the third peak as the second shoulder. When the price is at its highest peak (the head), you may think that the market is in a strong bullish move.
But the second shoulder at the picture already represents a lower high. This is the first sign of the price action that says the market is no longer interested to go higher.
Finally, the price breaks and moves below the second shoulder which indicates, the market is returning back to the place from where the bullish move was initiated.
And that’s the trick! Or you can say the “advantage”. Because now you’ve got a hint that price will dive downwards for a while. So, going short just after the break of the second shoulder is not a bad idea and that is how a head and shoulders pattern is treated and traded in the forex market.
Trading based on head and shoulder chart patterns are profitable. But, as we’ve said earlier, the most challenging part is to be able to spot such patterns correctly at the live market. Entering the trade at the right time and from the right place also plays a crucial part of your trading outcomes. Let’s see some examples for better understandings.
This is a 4-hourly USDJPY chart and we’ve spotted a head and shoulders pattern here. When the price hiked from the left shoulder to the head area, you may think of going long expecting another higher high of the market.
But what happened next? Instead of making a higher high, price action plotted a lower high (right shoulder) indicating the market is denying to go further up.
Once, the low of the right shoulder is broken, price starts to drop initiating a bearish momentum of the market. So, it started as a bullish trend but ended as a bearish one. That is why the head and shoulders pattern is recognized as the reversal pattern.
Well, you may still wonder about the trade executions like, how and when to enter the trade when a head and shoulders pattern is spotted. For your better understanding, we’ve used the same USDJPY chart as an example:
After the formation of a head and shoulders pattern, you need to keep a sharp eye on its right shoulder and look for a possible bearish break out below its level to go short. Before making the final move, the price may wait a bit at the right shoulder area.
It may keep coiling in a short-range for a while. We suggest, mark both the high and low of that particular short-range and trigger a sell whenever the low of the range is broken. Please also note that it is always important to put a stop-loss limit while trading.
A stop loss in a sensible place works as a safeguard of your trading capital. While trading the head and shoulders you may set the stop loss limit right above the high of the right shoulder.
The neckline entry technique
This is a less complicated way to trade the head and shoulders pattern. You’ll find the neckline when you manage to connect the lows of both shoulders just as the image below:
Here, we’ve connected the lows of both shoulders with a straight line to define the neckline of the trade setup. Now, the task is very simple, just go short whenever price breaks below the respective neckline.
Trading the head and shoulders using the neckline technique is comparatively an easier trading approach for the newbie traders. The stop-loss rule remains the same for the neckline trading technique (right above the high of the second shoulder).
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Inverse head and shoulders
Regular head and shoulders pattern indicates the bearish reversal of the trend thus, it only provides the sell signals. But this time we are going to focus on buy opportunities as well. Inverse head and shoulders are just opposite to the regular ones, it signals the bullish trend reversals along with the buy opportunities at the market.
This chart represents an inverse head and shoulders buy setup. The first lower low of the market is marked as the left shoulder. Sellers continued to push the market further down before the buyers come out to pull the price up and create a higher low.
This is a primary sign of the market that tells The bottom of the market is considered as the head and the immediate higher low of the market as the right shoulder. We’ve connected the highs of both shoulders to define the neckline. Buy triggers once price breaks above the neckline. You may set the stop loss limit just below the right shoulder.
- Head and shoulders pattern is a stand-alone trading technique. That means you do not need to depend on other forex indicators or tools while trading.
- Well recognized by market professionals for generating trade signals with better probabilities of success
- Market experts suggest a 1:2 risk to reward ratio is achievable by trading head and shoulders pattern.
- It generates fewer trade signals compared to other indicators. Thus, helps you to avoid overtrading and lead a much relaxing trading life.
The bottom line
In order to trade chart patterns like head and shoulders, you really need to focus on charts with sharp eyes. We recommend traders to start with demo accounts in order to practice it in live markets.
Try to spot the pattern as correctly as possible and execute the trade following the proper rules. Other than that, trading head and shoulders pattern is very exciting, reliable and can help you to grow your trading account in a consistent way. Good luck!