How To Trade The Head And Shoulders Pattern

Today I want to look at the ‘head and shoulders’ reversal pattern and how it can be a useful tool for your trading. Remarkably common, they are one of the most trusted charting patterns in technical analysis. But as they are built on the foundations of support and resistance, bear with me while I’ll quickly run you through the theory of those lines first.

Why Support And Resistance Works
Support and resistance are easy to define on a chart. Anyone can see the market bouncing off a certain price or line time and time again. What a lot of people tend to forget about support and resistance is that when either support or resistance is penetrated by a significant amount, they reverse their roles. Support becomes resistance and vice versa. This is important. Let’s think of the market psychology behind this.

Imagine a market starts to bounce off a support level and moves higher. There are only three types of people in this market, those who have bought and are long, those who have sold and are short, and the people who have done nothing. Maybe they never will.

So the market’s going up. The longs are delighted, although they wish they bought more. The shorts are getting nervous as nobody likes a position going the wrong way. Palms are starting to sweat, heart races a bit, and they are praying for a dip back to that area where they sold originally so they can get out without a loss. The longs are quite happy as everyone likes seeing profit on the screen and some of them start to sell. Now the other group, the undecided, are standing on the sidelines watching this take place and realise that prices are going up. Some of them are keen to get some of this action, and are committed to buying the next dip.

Now all participants in this market are committed to buying the next dip - greedy longs who have taken profit want in again, the stuck shorts want out and must buy, and some of the undecided have made up their minds - they want to buy as well, at the right price.

You’re still with me? Now at this point two things are significant - the longer a price trades at a certain level like this, the more significant that support or resistance becomes. Also, the more volume that it trades there, the more significant they are as well.

In this example, let’s say that instead of soaring, now prices move lower, below the support are where everyone has been buying it. Everyone who bought it realised they made a mistake. Now they want out. They hope it comes back just a little so they can get out. It was the presence of all those buy orders that created support in the first place, but now instead of buy orders people want to sell! See what’s happened? Support has become resistance! A lot of people tend to forget this when looking at charts, and it can definitely help when trying to figure out the next price objective or the next bounce.

The reason I brought this up was I briefly wanted to mention one of the most common price reversal patterns - the head and shoulders reversal pattern.

A Head And Shoulders Pattern Example

For the first half of the chart, prices move higher under strong momentum. Prices rise until Point (1) on the chart where we become overbought. The longs take profit for whatever reason, the market naturally breathes, and the market sells off. At Point (2), prices find support and rally again, even stronger this time, making new highs at Point (3). Notice however, that the momentum of this move is not as high as it was for the first rally, even though prices went higher. Ding-a-ling!! Warning bells!! Markets can’t sustain higher highs with lower momentum, right?

Prices fall again and find support at Point (4). The final rally, on the right shoulder up to Point (5) is smaller, slower to start (look at the couple of indecisive candlestick bars) and on low momentum. No surprises that we fail to make a new high.

Earlier on we touched on the fact that any uptrend that fails to make a new higher high is probably to be questioned. Prices sell off again, and we are thinking we don’t want to be long this market. It has all the makings of a head and shoulders pattern, one of the most common reversal patterns.

The key here is the neckline, a trend line of support until now. Once price breaks that neckline, we aren’t the only ones thinking we don’t want to be long anymore, and the order of the day is sell, sell, sell. Our confirmation is the break of that neckline. If you’re long, get out. If you’re short, stay short. If you’re on the sidelines, think about shorting it. You can get a minimum price target by measuring the distance from the head to the neckline, and projecting that downwards from the breaking point downwards as shown. That’ll give you a good idea of where to place your limit profit order.

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