THE HEAD AND SHOULDERS CHART PATTERN
The Head and Shoulders pattern is a classic pattern in technical analysis. It is a sign that a trend is about to reverse. This pattern is composed of a peak, followed by a larger peak, which is then followed by a peak of roughly the same magnitude as the first peak. The largest peak in the middle is called the “head.” The two smaller peaks form the “shoulders.” A trendline drawn at the base of all these peaks is known as the “neckline.”
A head and shoulders pattern began to develop in USD/CAD on April 5, 2018. Real-world head and shoulders patterns are not as well-defined as they are in textbooks and theoretical drawings. However, you can clearly see the head, and the two shoulders surrounding it. The right shoulder is not quite as pronounced as that on the left, but the fact that it forms a peak above the low produced after the head and the low at and below the neckline afterward is unassailable. The neckline is the trendline marked with the green line. The neckline is formed by connecting the low formed before the head with the low formed afterward.
It is vitally important to wait for the entire pattern to develop. Do not try to jump the gun and begin trading on a half-developed head and shoulders pattern–or any half-developed pattern for that matter. Always wait until the price has moved below the neckline, which is clearly the case in our example.
You can begin trading when the pattern has completely formed. As part of good trade management, you should always plan the trade out before you make it, recording the entry point, exit point, targets, and stops.
How to Trade It
The pattern is typically traded by entering at the breakout below the neckline. In our example, this trade would be a short. More conservative traders may monitor the breakout, waiting for a pullback up to the neckline, and then enter upon the confirmation of the breakout after continuation of the downward move. Doing this means you could miss out on the move, as we would have done in this case. But you would have avoided a loss if we had entered eagerly in mid-breakout only for the price to move back to the neckline and continue the larger trend upward instead of a reversal of the larger trend that was indicated by the head and shoulders pattern.
Where to Place Your Stops
There are various options for placing the stops for this trade. The most conservative of these being to place it just above the peak formed by the right shoulder. This keeps the risk small and allows for a good risk-to-reward ratio. In our example, this would be just above the right shoulder peak at around 1.2940.
The peak formed by the head could be used for a stop, but this would increase the risk of the trade. In our example above, this would be somewhere around 1.3110. The risk-to-reward ratio would require a lot of profit to justify the risk.
Setting Your Take-Profit Point
The anticipated move after the pattern is generally taken to be the distance between the neckline and the head of the pattern. This makes sense because if we use the right shoulder for the stop, which represents the risk, the reward will be represented by the distance between the head and the neckline, which is larger than the distance between the neckline and the peak of the right shoulder. The reward is greater than the risk, as it should be. In our example below, the distance from the neckline to the peak of the head is denoted in purple and mirrored at the point where we would have entered the trade. Our trade would be nearing its take-profit point.
If we used the head of the pattern for the stop and used the distance between the head and the neckline to determine the take-profit point, the risk and reward will be roughly equivalent. Over the long haul, this trade would need to succeed at least 50% of the time to break even. More long-term success would be found in positioning the take-profit point to where the reward is at least twice the amount of the risk. This would mean that the trade would only need to succeed 33% of the time to break even.
As always, it is wise to stick with good trade management and remain committed to your trading plan. This means getting out when your plan says to get out. Don’t worry if the price keeps moving downward. Let it go and move on to the next trade. Effective technical trading is about taking advantage of points in the market where we have a statistical edge. When you reach your take-profit point, the statistical edge is gone and it’s time to get out. You can tighten your stop and let the trade run if you choose, but you may be better served looking for more high-probability trades.
While this chart pattern looks impressive and infallible, you better believe that it’s not. No chart pattern is infallible. No chart pattern is right all the time.
Another issue is that chart patterns can be subjective. Some may see them while others don’t. Your stop will be hit sometimes and there are other times when your take-profit point won’t be touched. This is all part of the game. The head and shoulders pattern is just a way to recognize a situation where you have an advantage. Using it wisely and prudently can lead to great profits.