HOW TO TRADE HEAD AND SHOULDERS CHART PATTERN

How to trade head and shoulders chart pattern
Infographic - How to trade head and shoulders chart pattern

Entry: after breaking the neckline at point (6), either with an entry after the breakout, or after a possible retest of the neckline.

Take profit: identified by measuring the vertical distance from the head (3) to the reversal point from neckline that initiated the right shoulder (4), that measurement is then applied from the breakout rate (6)

Stop loss: can either be the neckline breakout rate (6), or the right shoulder's high (5)

HEAD AND SHOULDERS PRICE ACTION

This chart pattern starts forming with bulls already in control of the exchange rate's uptrend. As bears enter the market, they are tested by the bulls at three different occasions, the first and third ones are around the same rate, and the second one being the strongest push performed by the bulls. After the third bears' successful reversal, they finally break the neckline created by the bulls, and the exchange rate starts a downtrend.

Let's break down the pattern formation!

In an uptrend, price action finds the first resistance (1) that forms left shoulder's high.

Price action reverses direction from the first resistance (1) and goes downwards till it finds the first support (2), completing the left shoulder formation.

Price action reverses direction from the first support (2) and goes upwards till it finds the second resistance (3) that forms the pattern's head, which must be higher than the first resistance (1)

Price action reverses direction from the second resistance (3) and goes downwards till it finds the second support (4) that completes the head formation, which will be around the same rate of the first support (2)

Price action reverses direction from the second support (4) and goes upwards till it finds the third resistance (5) that forms the right shoulder's high, which will be around the same rate of the first resistance (1).

The pattern is completed when price action reverses direction from the third resistance (5) and goes downwards till it breaks the neckline at point (6)

NOTES ON HEAD AND SHOULDERS

Direction

Reversal

Type

Bearish

Occurrence

Low

Common term

Medium-Long

The neckline is identified by drawing and extending a trend line connecting the two support levels that completed the left shoulder (2) and the head (4)

Both shoulders don't have to be of the same height.

Neckline (2-4) can be skewed, usually in the same direction of the trend line connecting both shoulders highs at points (1-5)

Volume usually decreases as the pattern is being formed, and increases when breaking or retesting the neckline.

This pattern is commonly found on medium-term and long-term time frames.

HEAD AND SHOULDERS REWARD:RISK

When using the neckline's breakout rate as stop loss, R:R will depend on the (breakout rate-entry rate) distance, compared to the target measurement (head-neckline) distance.

When using the right shoulder's high as stop loss, the pattern's R:R improves when the shoulder's retracement distance (4-5) is short compared to the (head-neckline) distance.

Always remember that both stop loss levels explained above are absolute, the actual stop loss rate for your trade setup should be a bit beyond those levels to give the trade setup some room to breathe, and of course, calculations for position size and R:R should be done with respect to those rates.

HEAD AND SHOULDERS REAL TRADE

Head and shoulders real trading example
Forex chart - Head and shoulders real trading example, as found on the D1 chart of AUD/USD using FXCM's MT4 platform

PRE-BREAKOUT CALCULATIONS

Since a head and shoulders chart pattern can be spotted after the reversal from point (5), you can save yourself precious time by doing the following set of calculations before the breakout, since they don't rely on the trade's entry rate.

However, unlike other patterns where the breakout rate is fixed, a head and shoulders breakout rate is variable, depending on the time of the breakout. As a result, pre-breakout calculations are limited to pattern length and second stop loss.

  • Pattern length (point (3) rate - point (4) rate)
    • (0.97569 - 0.92645) * 10000 = 492.4 pips
  • Stop loss #2 rate (point (5) rate + 10% of pattern length)
    • 0.94472 + ((10 * 492.4 / 100) / 10000) = 0.94964

POST-BREAKOUT CALCULATIONS

The following set of calculations depends on the neckline's breakout rate, which is the variable point (6). It is highly recommended to complete them as soon as a breakout occurs, so you can focus more on the calculations needed for the actual trade.

  • Take profit rate (breakout rate - pattern length)
    • 0.92645 - (492.4 / 10000) = 0.87721
  • Stop loss #1 rate (breakout rate + 20% of pattern length)
    • 0.92645 + ((20 * 492.4 / 100) / 10000) = 0.93630

TRADE SETUP

Choosing when to enter the trade after the neckline breakout is always left to your best judgement. In this trade, we chose to enter the market at the closing rate of the candle that broke the neckline, which was a strong bearish candle, suggesting a real breakout for the neckline.

  • Trade entry rate
    • At the closing rate of the candle that broke the neckline at point (6): 0.92272
  • Take profit in pips (entry rate - take profit rate)
    • (0.92272 - 0.87721) * 10000 = 455.1 pips
  • Stop loss #1 in pips (stop loss #1 rate - entry rate)
    • (0.93630 - 0.92272) * 10000 = 135.8 pips
  • Stop loss #1 R:R (take profit in pips / stop loss #1 in pips)
    • 455.1 / 135.8 = 3.351
  • Stop loss #2 in pips (stop loss #2 rate - entry rate)
    • (0.94964 - 0.92272) * 10000 = 269.2 pips
  • Stop loss #2 R:R (take profit in pips / stop loss #2 in pips)
    • 455.1 / 269.2 = 1.691

Currency pair

AUD/USD

Timeframe

D1

Breakout

21-Nov-2013

Platform

MT4

Broker

FXCM