At last, the neckline is drawn across the bottom of the head and both shoulders serving as a support line. When the price breaks through the neckline, after forming the right shoulder, and keeps continuously falling, it indicates the completion of the Head and Shoulders Top formation. The Head and Shoulders pattern can also form in the opposite direction. Also known as the Head and Shoulders Bottom or the Inverted Head and Shoulders, the bullish version of the pattern establishes at the bottom of the downtrend and implies that the existing bearish tendency is likely to be reversed, and the price will head higher.
After the peak of the left shoulder is formed, the price goes up completing the first formation. Then it falls down to a new low followed by a recovery move upwards creating the head. A corrective reaction downwards occurs to start the formation of the right shoulder, and then the price makes a sharp move up once again. The neckline is then applied, serving as a resistance line.
Once the second shoulder is formed, the price will make a final rally, breaking through the neckline and indicating the completion of the Head and Shoulders Bottom formation and the reversal of the bearish trend. Another difference between the Top and Bottom patterns is that the Top formation is typically completed within a few weeks, whereas the Bottom formation may prolong up to several months or even a year.
Head and Shoulders Pattern
When dealing with the Head and Shoulders Top pattern, measuring the vertical distance from the top of the head down to the neckline helps to determine an estimated spread amount. Conversely, when dealing with an inverse pattern, the opposite is true: measuring the vertical distance from the neckline down to the peak of the head gives you a rough idea of how far the price is likely to go upward past the neckline. The Head and Shoulders pattern is a useful technical analysis tool for measuring and evaluating the minimum probable extent of the subsequent move of the price from the neckline.
It also allows indicating a reversal in a trend where the market makes a shift from bullish to bearish or vice-versa. This pattern is considered to be one of the more reliable patterns that predict a trend reversal. Knowing how to recognise the pattern and base a trade on it can be fruitful in the long term. It can also be seen as another great technique to implement in your overall trading strategy.
Head and Shoulders Pattern Trading Strategy Guide
The market is volatile; it always changes at a rapid pace. Partial or nearly completed patterns should be observed, but no trades should be made until the pattern breaks through the neckline. When trading the Head and Shoulders Top pattern, you expect the price action to move lower than the neckline. Calculate a profit target for the trade by measuring the height of the pattern from the peak of the head to the neckline.
Open a short position when the pattern completes and price breaks below the neckline. The inverse pattern is traded the same way. With it, you expect the price movement above the neckline. Find the difference between the high and low of the pattern to calculate the profit target. Take a long position when the price breaks above the neckline. In both situations, you can exit your position near the set target or keep it longer if the price continues to move in your favour until the next reversal signal develops. The key to mastering the Head and Shoulders trading is to be patient and wait for the pattern confirmation, as sometimes fake-outs might occur.
Head and Shoulders
With the Top pattern, stops are typically placed above the high of the right shoulder or above the high of the head price. With the Bottom inverse pattern, stops are usually placed below the low price formed by the head pattern. Spread betting TradingView. Indices Forex Commodities Cryptocurrencies. For traders. News and features Capital. Professional clients Institutional Economic calendar Capital.
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Log In Trade Now. My account. Trade with the Head and Shoulders chart pattern When watching the market, analysts and traders usually study various patterns and trends, hoping to detect the next price movement. When they are achieved, the pattern signals a reversal in trend. The first step is the forming of the left shoulder. It occurs when the price of an asset reaches a new top and retraces afterwards in our mining stocks example the left shoulder was completed in mid-March. The second step is the forming of the head.
This happens when a new top is established higher than the previous left shoulder top and the price comes back to the level near the left shoulder bottom in the above chart such a pattern may be noticed between mid-March and mid-May. The third step is the forming of the right shoulder. Another local top is formed, lower than the previous one lower than the head and near the level of the left shoulder top.
Once again, it is followed by a slump first days of June. The fourth step completes the whole pattern. The price falls below the neckline, which is a support level established by the lows between the head and the shoulders mid-June. After the completion of this formation there is a reasonable probability that price will continue falling even if it rebounds for a while.
A short period of growth would probably be followed by a retracement to the neckline and by further declines. However , it is essential to wait and verify the pattern as the main move will most likely occur after the verification. You should always remember that the head and shoulders pattern is not always validated.
If a significant move up on high volume takes place during the verification phase, the whole pattern might be invalidated. This was ultimately the case in the example from our previous chart. Volume plays a significant role in the confirmation of a trend and this is particularly the case with gold and the rest of the precious metals market.
In the head and shoulders top formation it is important to have the price decline below the neckline confirmed by high volume. Significant volume signals that there are a lot of sellers in the market, which means that supply and demand are moving in the directions our formation suggests. Speaking of volume, please note that in our example volume was declining during rallies and rising during price declines, and thus the formation was quite reliable. Moreover, from early June on, all daily counter-trend rallies were seen on low volume levels, whereas declines were accompanied by high volume.
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This was a bearish sign. The neckline, based on both the daily closing prices and the intraday lows, was broken. The breakdown took place on significant volume and the preceding rally had been accompanied by low volume. This was a very bearish combination. Remember that if we see a move higher up to the neck levels, and this move takes place on low volume, then it most likely serves as a verification and not invalidation of the breakdown.
So, if available, you should always check volume for a confirmation of this formation if you want to take any action based on it. Another very useful feature of this formation is that it allows us to calculate a target price for the decline. This will be discussed using the chart below. You can easily see that the head and shoulders formation was completed. The price tested the neckline the resistance level , and declined afterwards.
Now, imagine that we are in that precise moment when the price broke down below the neckline. Since we already know the price direction from the confirmed pattern , we can now forecast how big that move will be. To do that, we might use the target price.
This is a measure of where the price is considered to be headed, based on the confirmed pattern.
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Take a look at the chart above. The target price is marked in the range of to How did we get these numbers? In the simplified method, the target price is calculated by subtracting the difference between the head level and the neckline level from the neckline level. You may notice that is slightly different from the target level of to marked on the chart and mentioned before.
Why is that? The explanation is that in the chart we used a logarithmic scale not the linear one. The logarithmic scale is better for substantial moves and that is the case in the above chart. Because of that, we need to use a different method. This alternative method calculates the range in relative terms. The first step is to calculate the distance between the neckline and the head in relative terms. Then we apply this distance to the end of the neckline. This value is consistent with our range of to We do not consider the target price an extremely precise prediction but rather an indication of how strong the price decline might be that is why we would prefer to assume that the target price is in the range of to rather than at the level of The rule is quite simple here: the greater the distance between the head and the neckline, the lower the price is headed.
To sum up, the head and shoulders top formation is quite common in technical analysis and it can be seen every now and then on the gold market. However, you have to be careful and wait for a confirmation of this formation by a move lower on high volume or wait for verification a small rally back to the neckline.
We hope you enjoyed reading the above definition. If you'd like to learn more about gold and in particular about its most recent price swings and their implications, we invite you to sign up for our gold newsletter. It's free and if you don't like it, you can easily unsubscribe. Sign up today. The inverse head and shoulders formation also known as reverse head and shoulders formation is one of the most popular and reliable formations used in technical analysis.