Head & Shoulders, Chart Patterns, Edition #1 (29/08/2021)
NEW - Simplify your technical analysis with our super cheatsheets and trading checklists with a serving of q's secret sauce 👇 Boost accuracy and uncover more reliable bearish reversals now 🎯
Head and Shoulders: Classic Bearish Reversal Pattern
Bearish reversal - uptrend into downtrend
One of the most reliable classic chart patterns
Best observed at market tops
Volume is crucial
What is the Head and Shoulders chart pattern?
Head & Shoulders (H&S) is a widely-known chart pattern in technical analysis. The formation of this pattern is considered one of the most reliable bearish reversal patterns that can appear on price charts in any financial market.
H&S is a classic chart pattern that indicates a possible reversal in price action. When the H&S appears, this signals a likely downside move against the previous uptrend.
Head and Shoulders can take minutes or decades to form and appear on any financial price distribution chart. The pattern also offers a simple set of principles for identifying position entries, exits and price targets - making it a fantastic choice for traders of all experience levels to study.
Qluster analysts caution against limiting due diligence to just one technical indicator. Instead, optimise decisions by referencing other indicators and analysis for a more robust reading.
Q's Advanced Technical Principle: The scope of technical analysis inherently involves recognising the underlying human psychology within a price distribution chart.
How to find Head and Shoulders (for any price chart!)
The Head & Shoulders chart pattern is a relatively simple formation - which is why it can be a great first step for beginners or traders new to pattern trading.
As well as producing reliable bearish reversal signals, multi-asset traders may find this chart pattern highly versatile.
Our guide and cheatsheets are applicable to the following financial markets:
Foreign Exchange (Forex)
Stocks and equity markets
How to identify the Head and Shoulders reversal pattern
Qluster analysts find the simplest way to identify the Head and Shoulders on any price chart is by breaking down the pattern into five parts:
Left Shoulder (LS)
Right Shoulder (RS)
Deepen your understanding with this visual guide…
Diagram of Head and Shoulders - Five Parts of the Pattern
Observe from the illustration above, Head and Shoulders is a pattern that shows three consecutive highs located at different levels.
The levels include two lower highs (LS, RS) separated by the highest high (H). A neckline connects the two local lows produced at LS and RS.
Understanding how to identify the Head and Shoulders is the first step of trading the pattern successfully.
Now, the savvy trader might ask...
"How can the Head and Shoulders pattern produce reliable results on Forex, Stocks and Crypto charts?"
"What causes the H&S to form?"
👇 Let’s answer these questions by looking at the psychological drivers behind H&S below 👇
Market psychology behind the Head and Shoulders formation
There's an age-old debate in the trading community - is technical analysis a science or an art?
Q's perspective is that technical analysis is a unique hybrid between a science and art form.
Studying technical indicators is a systematic and objective approach to analysing market data. But, it is also a finely tuned discipline where traders realise the perfection of their art through rigorous development of their strategy.
It doesn't matter which side of the aisle you lean towards - science or art - there is one thing the community can agree on:
The art of technical analysis is an evidence-based approach to identifying trends or reversing trends and maintaining this trading posture or position for as long as possible - until the weight of evidence suggests otherwise.
Q's Advanced Technical Principle: Technical traders base their decisions on the assumption that humans will make the same mistakes
i.e. hoomans will be hooman!
How the Head and Shoulders formation really works
The markets as a reflection of human psychology also tend to be equally as unpredictable as people themselves.
Despite an infinite combination of individual circumstances and unique social nuance, there are several possible explanations for why the Head and Shoulders chart pattern works.
Read the short narrative below that highlights the psychological mechanics behind the Head and Shoulders chart pattern.
In this hypothetical scenario, try to place yourself in the shoes of the imaginary market participant 'Jimmy'...
Jimmy's friends tell him to buy QlusterCoin as they believe the price is about to make a break to the upside. However, Jimmy is inexperienced in technical analysis and misses the optimal uptrend by not taking action.
He wakes up the next day to the news that the QlusterCoin rally was more explosive than expected, with price action smashing through previous resistance levels to set new highs. Cursing in frustration, Jimmy frantically opens his trading platform and executes his intended market order. Afraid to miss out on more gains, Jimmy reasons it is appropriate to increase his position size.
Jimmy tries to justify chasing the breakout by telling himself, "After all, I also need to try and recoup missed profits from not entering his position earlier, right...?"
The trade dips lower, and a restless Jimmy tries to sleep off the doubt.
Checking back on his position later in the week, Jimmy claps his hands gleefully as his trade is now showing a very healthy profit from a sustained bull run.
Basking in exuberance and greed following his successful gambit, Jimmy sighs with relief and muses about how he'll spend all the profit he will make.
Jimmy assures himself that he will manage his trade after work. His optimism is fuelled by seeing friends on social media post "Qluster to the MOON". Even the mainstream news outlets are joining the publication of QlusterCoin's phenomenal run-up!
It's a crazy period at work for Jimmy, and he's unable to manage his position as intended. Upon his next login, Jimmy is stunned to see he had lost almost all of his gains. The cold touch of melancholy fills his body as a quick search online reveals that a 'certain' CEO tweeted about QlusterCoin, and the prices tanked suddenly.
Brimming with indecision, Jimmy stares blankly at his monitor as the prices drop lower and lower. But, unfortunately, his trade is now back in the red. Jimmy, his mind clouded with uncertainty, decides it's all or nothing and prepares to make a new 'recovery' trade with the remainder of his margin.
Choking back tears, Jimmy is desperate to do anything to walk away from this trade without a loss. Staring intently at the chart, he fixates on closing his positions at breakeven.
The names and examples used in this narrative are purely fictional. References to QlusterCoin are intended for demonstrative purposes only.
Remember! Jimmy's is just one imagined example of countless real-life variables and unique human elements at any given time in live market settings.
Using this new outlook on technical analysis, here are some additional technical arguments for why the Head and Shoulders works as a reliable bearish reversal pattern.
Why is Head and Shoulders a reliable bearish reversal pattern?
Bears execute market orders after a second rally to the Head (market peak, high) and begin to escalate activity when aggressive buying subsides.
Traders who entered on the final uptrend expansion to the Head, or the antecedent rally to RS, are proven wrong as price action retraces to the neckline. Long positions are now in loss - portfolios show red, and loss aversion kicks in for many participants. This potentially large group of traders will eat their losses and exit positions, driving the price downside towards Head and Shoulders price targets.
Price targets for H&S assume participants who pursued the previous extended move up will soon opt for forced closure or involuntary liquidation (e.g. margin call) of their positions. The sum result of these poor trading decisions cultivates the necessary conditions to create a bearish reversal of similar magnitude.
One of the reasons why the neckline features prominently in this reversal pattern is its representation of financial pain for many traders. Thus, for many participants who incorrectly entered the previous topping pattern, price action towards the region marked by the neckline will mean forced position exits.
Practice mapping out the human nature in price action to help deepen your perspective and gain invaluable insights into what the Head and Shoulders pattern means for traders like Jimmy.
Qluster analysts have put together a graphical representation of human psychology - a.k.a. mistakes - imagined to be driving the Head and Shoulders formation in this example:
With the psychology of other market participants like Jimmy in mind, proceed to the next section below to learn how to trade the Head and Shoulders chart pattern.
Qluster Research readers will have free download access to Q's H&S handy cheat sheet and trader checklist in the later sections of this article.
How to trade the Head and Shoulders reversal pattern
Like all other functions in technical analysis, it is clear that underlying human psychology also drives the Head and Shoulders pattern across markets.
Apply this new perspective of H&S to these five simple guidelines for detecting possible entry signals.
Find Head and Shoulders on any chart with 5 Simple Steps
Step 1) Pattern forms after an extended upside move
Recall that the Head and Shoulders is a bearish reversal chart pattern that can appear in any market and on any timeframe.
Naturally, validation of a possible Head and Shoulders formation begins with checking the antecedent (previous) trend is bullish.
Many technical practitioners consider the H&S to be the most reliable reversal chart pattern formations at market tops.
Head and Shoulders can form as trend continuation patterns. The principal difference between H&S as a reversal or continuation formation is when they occur during the trend cycle.
i.e. Reversal H&S occurs at the market top. Continuation H&S occurs during the trend
Step 2) Both Shoulders are below the Head
Q does not doubt that most investors and traders have come across a representation of the Head and Shoulders pattern at some point in time.
For some of our readers, both shoulders below the head seem like a no-brainer.
But when asked to explain why shoulder positioning is so vital, the usual response is a blank look...
If you're unable to answer this question, you might be missing the most critical concept.
Head and Shoulders = Bearish reversal chart pattern
Recall that the H&S forms after an extended upside move. It also signals a possible uptrend reversal to the downside.
Why descending necklines could be trouble for Head and Shoulders formations
Left Shoulder (LS) was higher than the Head (H), then the trend reversal may be underway already, or analysis is lagging
Right Shoulder (RS) was higher than the Head (H), then the trend reversal has failed into possible continuation or consolidation
Is it possible to raise your shoulders over your head? For most humans, the answer is - NO!
The same limitations apply to the Head and Shoulders pattern.
Step 3) Horizontal or ascending neckline is optimal - beware of descending necklines
The neckline is an essential component of the Head and Shoulders chart pattern that plays a leading role in its formation.
For technical traders, the neckline serves as a way to confirm:
Direction of the local trend
Validity of the distribution pattern
Confirmation of antecedent trend reversal
Position management strategy
Violation of the neckline is a significant event, indicating the support zone where price action breaks the previous trend sequence of higher highs and higher lows.
Drawing necklines follow similar technical standards to trendlines when using the Head and Shoulders chart pattern in a trading strategy.
Two-step check of neckline analysis
Neckline is a straight line that connects two lows located at the troughs between LS, H and H, RS
Joining the two local lows produces an uptrend or horizontal trendline
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A downward sloping neckline contradicts step one covered previously:
Pattern forms after an extended upside move.
It may be wise to move on to other higher probability opportunities if you notice a neckline that moves from top left to bottom right.
Step 4) Decreasing volume on the right shoulder (RS)
Volume is essential to confirm a true Head and Shoulders formation on any price chart and timeframe.
Certain characteristics can provide evidence to support a valid bearish reversal signal. An unsteady or inconsistent volume detracts from the likelihood of a true uptrend breakdown.
Q's Volume Trading Principles: Head and Shoulders
As a general guide, activity is usually heaviest during the left shoulder formation (LS). Volume tends to maintain weight as prices continue a rally to the second peak or Head.
The first sign the Head and Shoulders pattern is under formation lies in the third peak - or Right Shoulder (RS).
Volume may appear distinctly lower on the formation of the third rally. In such cases, the level of volume will continue contracting as the peak of the Right Shoulder is reached.
Q's Secret Sauce: Head and Shoulders
The fifth step is a special one from the Qluster team - seeking additional confirmation of the bearish reversal before entering positions.
Price patterns are like any other technical indicator - they can fail!
Sometimes a perfect set-up will appear, only to discover that price action never returns to the neckline. Perhaps, it was a false pattern that fails after breaking past the neckline and results in a bullish continuation to stop loss.
Our aim as technical practitioners is to apply an objective, evidence-based approach to identifying trends and trend reversals.
A more conservative approach to finding bearish reversals with the Head and Shoulders chart pattern is to wait for a successful bearish retest of the neckline after its initial breakdown.
Following the initial neckline break down after the RS, allow bears time first to produce a successful retest at the neckline and confirm a successful reversal of the antecedent bullish market structure. Benefits may include:
More reliable reading of failing buying activity
Valid analysis of latent supply
Higher probability of identifying more authentic Head and Shoulders chart patterns
Be patient and allow an objective judgment of price action to provide evidence of reversal authenticity.
For illustrative purposes, Qluster analysts map out two alternative entries below.
Examples of Head and Shoulder Pattern Entries
Boost the probabilities by finding Head and Shoulders formations that appear after an extended move up.
It's impossible to raise your shoulders over your head - which is why both Shoulders must be below the Head for the pattern to be valid. Be wary of descending necklines and observe key volume characteristics as RS undergoes formation.
Allow price action to produce evidence of a successful bearish retest at the neckline for a more robust reversal pattern.
Understanding how to find Head and Shoulders on any price chart is a simple way for technical traders to identify reliable bearish reversal signals forming on any timeframe.
Last but definitely not least - always wait for the pattern to complete before taking action!
Rushing into positions without confirming the validity of either the pattern formation or reversal break is a brilliant strategy for donating your capital to the markets.
👇 Download the Head and Shoulders Trader Checklist for free 👇
Trader Checklist: Head and Shoulders with Q's Secret Sauce
Pattern must form after an extended upside move - recall this is a bearish reversal pattern
Left Shoulder (LS) and Right Shoulder (RS) are both below the Head
Horizontal or ascending neckline is optimal - beware of descending
Decreasing volume on the right shoulder (RS)
Secret Sauce: Don't play with fire! Wait for a successful bearish retest to confirm the trend reversal...
Qluster analysts specifically designed our checklists to be practical, help improve price pattern fluency, and achieve technical acuity sooner!
Q's Position Management: Head and Shoulders Reversal Pattern
The versatility of this classic bearish chart pattern is renowned for multi-asset traders.
When accompanied by decisive confirmation of a bearish break below the neckline, this pattern produces reliable signals of an uptrend reversal across many financial markets.
As well as boasting strong performance across every chart timeframe, the Head and Shoulders pattern offers a surprisingly simple method to projecting targets and managing stops.
Risk Management for Head and Shoulders (Stop Loss)
According to technical theory, managing Head and Shoulders with a stop above the Right Shoulder (RS) is logical.
The significance of RS? It’s the first successive peak that breaks the subsequent uptrend sequence and bullish market structure. Ergo, it is unlikely for price action to break the Right Shoulder unless of uptrend continuation due to pattern failure.
How to estimate Head and Shoulders price targets (Take Profit)
Projecting potential profits is an essential step in money management and helps traders plan their exit strategies by indicating realistic and probable price expectations from the market.
According to technical theory, pinpoint an appropriate target level for Head and Shoulders by measuring the distance from the highest peak (H) to the neckline.
The distance 'H' can indicate a possible price target below the neckline and requires minimal technical proficiency to try:
How to use parallel lines for mapping dynamic price targets
Qluster analysts offer a simple adaptation of the minimalist approach above. Refine the technique using parallel lines for a practical and highly effective approach.
Parallel lines follow equidistance principles. Therefore, this way of measuring price targets factors in the unique neckline gradient and may improve accuracy.
Try to project price targets for the Head and Shoulders bearish reversal pattern with the following three steps:
Measure the height of the Head (H)
Measure the distance H in the direction of the breakout from the breakout point. Mark this point Alpha as 'A'
Draw a set of parallel lines to the H&S neckline from point A
Here's a graphical illustration to help you understand:
See you again for the next update. - q
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