Head and Shoulders pattern and the inverted version of it are classified as the reversal patterns of the Forex, that is, if appeared at the end of the trend, they reverse the direction of the trend after the pattern being formed.
This pattern is known as the Head and Shoulders pattern because it has two tops on sides with equal size (shoulders) and a top in the middle with a higher height (head).
.The lowest level of bounce in this pattern, which is the support or resistance level, is known as the neckline
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Getting Familiar with Normal Head and Shoulders Pattern
Head and Shoulder Pattern is classified as a reversal pattern that is formed at the end of an uptrend and is a sign for imminent reversal of the market trend.
This pattern has three tops, the middle one of which is higher than the other two peaks and is known as the head, and the two other peaks on either side of the head are shorter and about the same height as the shoulders.
Head and Shoulder Pattern is formed on the resistance level in an uptrend. This resistance level, which acts also as a support level, is known as the neckline.
Head and shoulder pattern is not of those patterns that are formed in weekly or monthly chart, but the formation of this pattern in daily timeframe may take several months to several years to complete and a lot of daily data may play an important role in forming this pattern.
Therefore, changing the market trend after this pattern will not happen in short-term and usually the trend reverses in the midterm to long term.
The image below shows the appearance of the typical head and shoulder pattern in a rising trend.
The chart above shows the formation of the head and shoulders in daily timeframe.
As you can see, daily data for about a year has been able to create such a pattern.
The chart above shows the different parts of the pattern including head, shoulders, neckline and the size of the formation in an ideal pattern, each of which have different and specific rules and interpretations.
Head and Shoulders Pattern: Specifications
You may see many patterns in the daily chart that are similar to the typical head and shoulders pattern, but all the conditions of a pattern are to met, otherwise you cannot interpret it as the head and shoulders.
⦁ Pattern Trend: Trend reversal patterns should appear at the end of a midterm or long term trend to change the direction of the trend. For this pattern, there should be a midterm to long term uptrend.
⦁ Left Shoulder: The left shoulder is the first stage in the formation of the typical head and shoulder pattern and the trend should correct or reverse after formation of the peak. This correction is the biggest price fall in the current price range.
⦁ the Head: To form the head, after the formation of the left shoulder, the price starts to rise and crosses the peak of the left shoulder and makes the highest price level, then the price falls or corrects again. It continues to fall until reaching the previous level and sometimes may stop with a slight difference from the previous level.
⦁ Right Shoulder: The trend rises again after correcting and reaching the level of the previous fall, and this time this rise is to the peak of the left shoulder. A slight difference with the left shoulder is acceptable but should not be dramatic. In fact, the shoulders hit a range of resistance. This time the price falling from the right shoulder should be fast and powerful. Until the neckline is broken.
⦁ Neckline: The neckline is composed of the left shoulder and the head by drawing the falling points (points 1 and 2 in the image below). The neckline is not always a horizontal line and may have an upward or downward incline. It has a direct relationship with the future downtrend.
⦁ Trading volume: With the widening of the Head and Shoulders pattern, volume plays an important role as verification. Volume can be measured by an indicator (OBV, Chaikin Money Flow) or simply by analyzing the volume. Ideally, but not always, the volume should be greater when the left shoulder is preceded by the head. The decrease in volume when forming new head is a warning sign. The next warning sign occurs when the volume decreases from the top of the head, and then decreases as the right shoulder develops. Final confirmation is done when the volume increases when the right shoulder falls.
⦁ Breaking the Neckline: The neckline plays the role as the support level. As we said, the price drop from the right shoulder must be strong and fast to cross over the neckline. Until the support level is broken, the head and shoulder pattern is not complete.
⦁ Turning Support into Resistance: When the support level or neckline is broken, the price actually starts to fall and the support level should play the role as resistance level this time. Correction of the price again after the broken neckline (not passing through it) is again a sign of starting a downtrend.
⦁ Profit Target: The price target or TP is equal to the distance from the head to the neckline. This means that the downtrend will continue at least to this extent. To find out about the end of a downtrend, other analyses should be used such as Indicators, Fibonacci levels and …
How to Analyze a Typical Head and Shoulder Pattern?
The image above shows the chart for the CNET Networks (CNET) stock, which shows head and shoulder pattern over six months.
In this chart, after the first peak of the uptrend, the price corrected to the point 1 to form a left shoulder.
In the next move, the uptrend shows the last attempt by the buyers as it has crossed the price high and then the price drop has continued to a little above point 1.
The neckline is drawn from point 1 to 2 with a slight upward incline, which indicates a strong downtrend after the formation of the pattern.
Then the rising trend begins to form the left shoulder, and in return the trend has enough strength and acceleration to break the neckline with strong falling candlesticks.
Size of the price drop after breaking the neckline is equal to the distance from the head to the neckline, but this step is not a good time to enter a sell position.
The downtrend after the drop, is to the size of the distance from the head to the neckline which begins a corrective movement, which confirms the new resistance.
The best time to enter a sell trade is after the turning the support level into the resistance that it is confirmed by the return of the downtrend.
Important Tips on Typical Head & Shoulder Pattern
How to interpret the Neckline: The neckline at the head and shoulders is not always drawn horizontally, but may have an upward or downward incline.
If the neckline is sloping downwards, it is a sign of weakness in the market and it forms usually a weak right shoulder and you have to wait a little longer than "the neckline breaking" to enter the trade.
If the slope of the neckline is upwards, it is a sign of market strength and the neckline will be broken with sufficient speed and strength after the formation of the right shoulder.
Enter the Trade in Head and Shoulder Pattern: This pattern is a sign of a change in the direction of the market trend in the midterm and long term, so do not rush to enter the trade. Let the neckline be broken and the resistance level be confirmed, then enter a SELL trade.
Confirmation of Resistance Level: It can be done in different ways, usually a corrective move in the downtrend confirms the resistance level.
Price gaps or single candle patterns after the neckline broken can also be a signal to enter the trade. You can also use indicators to get a signal.
Stop Loss and Take Profit: To identify the profit target, the distance from the head to the neckline should be calculated and the profit target should be determined from the neckline at the same distance. E.g. if the distance from head to the neckline is 50 pips, TP will be placed 50 pips farther or below the neckline.
To Confirm the Stop Loss, the high price of the right shoulder can be determined as SL. If the distance from the shoulder to the head is short, the head price can also be considered as SL.
Getting Familiar with Inverted Head and Shoulders Pattern
Head and Shoulders Pattern (Inverted), also known as the inverted head and shoulder pattern, is a reversal pattern, like the normal head and shoulders pattern, except that it appears at the end of a downtrend and is a sign of change in the trend.
The main difference between these two patterns is in the volume of transactions, although the volume of transactions is important in the normal head and shoulders, but a high volume of transactions is a MUST for the inverted head and shoulders.
This is due to the nature of the market that if there is a case of lack of volatility and low trading in the price movement, the market tends to fall, so to convert the downtrend to an uptrend, the trading volume must be higher to maintain the uptrend.
Inverted Head and Shoulders Pattern
In order to distinguish the inverted head and shoulder pattern from similar fake and invalid patterns, you need to know each part of the pattern very well.
⦁ Pattern Trend: To change the downtrend to an uptrend, the inverted head and shoulders must be formed in continuation of a midterm or long-term uptrend.
⦁ Left shoulder: The first valley is the continuation of the downtrend and is a risk for falling into the downtrend that forms the lowest price (bottom) in the chart and then there is a price correction which is formed to form the first shoulder.
⦁ Head: After the price corrected, it resumes the downward movement and crosses the bottom of the price valley, registers a new low price and the price corrects again to the approximately previous price correction and forms the neckline.
⦁ Neckline: The price correction of the left shoulder and the head of the pattern is in a range where the plotting and connecting these two points together forms the neckline, which may be horizontal or slightly inclining up or down.
⦁ Left Shoulder: this is the last attempt by the sellers, the downtrend resumes once again and advances as much as the left shoulder or valley or price low. After that, it resumes the uptrend with a fast and powerful movement to break the neckline.
⦁ Trading Volume: When the price reverses from the right valley, the trading volume must be high to confirm the pattern as the head and shoulders pattern.
⦁ Neckline Breakout: The neckline or the resistance level should be broken with a high volume of buying transactions.
⦁ Turning Resistance into Support: After breaking the resistance, the resistance should turn into support and the possibility of reversing the downtrend should be very low. Most of the time, the price returns to the resistance level, but this level provides a second buying opportunity by supporting the price.
⦁ Price Target: profit target for this pattern is the same as the distance from the head to the neckline.
This article was for Price Action training.