Fact: Every trader should know the head and shoulders pattern. No exceptions.
The head and shoulders chart is one of the best stock indicators available.
Why? Because it can help you spot incredible trading opportunities!
Don’t overlook this chart pattern when you’re researching trades. Once you understand it and learn how to trade it, you’ll have a powerful tool in your bag of trading know-how.
But what exactly is the head and shoulders pattern? And how can you use it to your advantage?
Let’s dig in.
Table of Contents
- 1 What Is a Head and Shoulders Pattern?
- 2 How to Trade Head and Shoulders Pattern in 6 Steps
- 2.1 #1 Identify Market Trend
- 2.2 #2 Plan Your Entry and Stop Losses
- 2.3 #3 Setting Your Target Profits
- 2.4 #4 Volume and Volatility
- 2.5 #5 Stick to the Daily and Weekly Timeframes
- 2.6 #6 Follow News Catalysts
- 2.7 #7 Locate the Best Opportunities with a Stock Screener
- 3 The Bottom Line
What Is a Head and Shoulders Pattern?
A head and shoulders pattern is fairly easy to identify.
This chart formation has three peaks. A taller one forms in the center (the head), and two of similar height form on the left and right (the shoulders).
Here’s the most important thing you need to know about the head and shoulders stock chart …
It predicts a bullish-to-bearish reversal.
When you spot this pattern, odds are pretty good that an upward trend is coming to an end.
On the other hand, this pattern can also suggest the opposite — a downward trend is about to reverse.
Let’s take a closer look at what’s happening in a head and shoulders pattern:
First, a stock’s price rises to a peak, before falling back down — that’s the first shoulder.
Then it rises to a second, even higher peak, then falls again. You guessed it: That’s the head.
Finally, it reaches one last peak, at around the same level as the first shoulder. Then the price plunges back down. There’s your second shoulder.
The line identified by the low points, or the troughs, of the chart is the neckline.
Now you know what it looks like … but what the heck does it all mean?
In short: This pattern shows you that a stock’s momentum is on a decline.
The repeating peaks and troughs are a painting a picture:
The bulls fight to sustain an upward movement, while the bears resist and try to drive the price down.
Once you see that price drop for the third time, it’s clear that the momentum is lost. Time to short the stock.
Benefits of Trading a Head and Shoulders Pattern
So what’s the big deal? It’s just another chart, right?
Wrong. The head and shoulders pattern is one of the more reliable chart formations.
Reliability is fundamental to both identifying great trading opportunities and making smarter trades.
Way too many traders throw money away — making blind trades without studying the market or analyzing stock charts.
Sure, sometimes they win. But, more often than not, they lose big. The reason they lose is usually due to a lack of education. That’s one of the most common trading mistakes.
Here’s what separates the smart, disciplined traders from the fray: They know the importance of knowledge and research. They use reliable chart patterns to make more reliable predictions.
And speaking of reliable patterns …
… The head and shoulders pattern is one of the easiest to spot. And its risk is minimal compared to many other trading patterns and strategies.
Of course, no pattern is 100% reliable, but no trading strategy is. Your task as a trader is to develop a strategy that helps you better manage your risk.
Go ahead, try your hand at blindly picking stocks … maybe you’ll get lucky.
But that’s not strategy. That’s gambling.
Why not just throw away your trading funds on lottery tickets or slot machines?
If you want to trade smarter, you’ve got to think smarter. Make better-informed trades. Use everything at your disposal to manage risk.
That’s where the head and shoulders charts come in.
Learning how to spot this chart formation and how to trade this pattern — effectively — can be another key tool in your trading toolkit.
Example of a Head and Shoulders Pattern
Now let’s break down how to identify a head and shoulders pattern.
Don’t worry. It’s pretty straightforward.
Say a stock’s baseline price is $3.
The bulls rally and drive the price to peak at $7 …
But they lose momentum to the bears. The price falls back down to around $3.
But the bulls aren’t done yet. They try to regain momentum and push back against the bears. The price peaks higher, around $10.
In some cases, this is where it ends. The bulls win, and the stock continues to climb. That means no head and shoulders pattern.
But in other cases, the bulls can’t sustain the growth. Instead, the bears pull back. The price plummets back down to around $3.
At this point, you can guess what happens next: The bulls push back but can only reach the same peak as the first time around — about $7.
The bears see that the bulls were unable to reach new highs. They take over, drive the price back down to new lows.
The reversal is complete. The upward trend is over.
You just witnessed a tug of war between the bulls and the bears. Sometimes the bulls win. But in this head and shoulders pattern, the bears win.
But what about an inverse head and shoulders pattern?
Inverse Head and Shoulders Stock Chart
Just as the name suggests, an inverse head and shoulder stock chart is the opposite of the standard pattern.
Instead of an upward trend reversal, you’re looking at the reversal of a downward trend.
Let’s look at another example. And in this case, the neckline is at the chart’s high points, rather than the low points.
Okay … so say the neckline of a chart is $3.
The price falls to around $2, then rebounds back to $3.
The price falls further, to around $1. Then it returns to $3.
Finally, the bears pull back once more. But the price only falls back to $2 before climbing to $3 and higher.
Key takeaway: This pattern signals a bearish-to-bullish reversal.
This chart pattern can also be referred to as a head and shoulders bottom.
Now, traders generally short a standard head and shoulders pattern once the neckline is crossed.
But in an inverse head and shoulders chart, traders will usually take a long position when the neckline is crossed.
Head and Shoulders Chart Pattern Breakout
A breakout is a point where prices cross the neckline of the chart.
On a standard head and shoulders chart, this means the price plunges to new lows. For inverse patterns, the breakout is the point where the price passes its previous high.
Breakouts are indicated by a significant increase in volume as investors identify the new trend.
Timing is everything here. Getting in at the beginning of the breakout can be key to maximizing trading potentials.
How to Trade Head and Shoulders Pattern in 6 Steps
Now you understand what a head and shoulders pattern is, what it does, and how to spot it.
Let’s get into the gritty: Learning how to use this pattern to bolster your trading success.
A head and shoulders stock chart can signal potentially incredible trading opportunities, but it’s up to you to take advantage of them.
Now let’s talk rules. The rules for trading head and shoulders pattern are very important, so study them thoroughly.
Add the following steps to your plan to start trading this chart pattern …
#1 Identify Market Trend
First, you need to identify the direction of the trend.
Both bullish and bearish patterns can offer promising opportunities.
But you have to know exactly what you’re dealing with before you can take the correct position.
Bearish Head and Shoulders Pattern
Bearish head and shoulders pattern have three peaks before dropping below the neckline.
It means the bears won. The stock’s upward trend is coming to an end.
In this case, you should take a short position in anticipation of the price dropping even further.
Bullish Head and Shoulders Pattern
Now guess what you’re looking at with a bullish head and shoulders pattern …
That’s right! It represents the end of a downward trend.
You’ll see this start to form as the bulls continue to build momentum in their fight against the bears.
Here you’ll see prices drop three separate times — rebounding each time — before finally crossing the neckline and climbing to new highs.
Traders generally enter into long positions when they see prices cross the neckline. Those prices will likely continue to rise as the bulls continue to push.
#2 Plan Your Entry and Stop Losses
First, you need to plan your entry, and you need to plan it carefully. It’s critical to do this well before you enter into a trade.
Set your criteria. Decide what benchmarks need to be met for you enter into a trade.
For example: Once a price drops below the neckline, you might wait to see increased volume before shorting the stock.
Next, plan your stop loss.
Decide — beforehand — when to pull out if things aren’t working out as planned. Remember to cut losses quickly.
If things aren’t going your way, don’t wait to see if it turns around. Pull out before you lose any more than you have to.
#3 Setting Your Target Profits
A lot of people ask: “Why pull out when things are going well?”
This can be tough for a lot of traders …
Obviously, the goal is to maximize profits. And it might seem counterproductive at times, but this is exactly why it’s smart to pull out once you hit your targets.
You need to be willing to pull out of a position.
Be disciplined. Don’t get cocky. And don’t get greedy. Greed can lead to bad decisions.
And if you’re scared of missing out on the elusive ‘more,’ just think about losing it all. Winning is always better than losing.
Head and Shoulders Pattern Indicator
Now that you better understand the head and shoulders pattern, it’s time to put it to work.
Use a head and shoulders pattern indicator to identify both head and shoulders and inverse head and shoulders patterns.
Once you find them, you can monitor the progress.
This can be key to finding trends early and establishing reasonable targets.
You’ll be better prepared to enter into a trade when the opportunity is ripe for the picking.
#4 Volume and Volatility
Predicting price action? Confirming trends?
Then you have to understand volume and volatility.
You can use the head and shoulders pattern volume to confirm a breakout really is happening.
If you think a trend is reversing due to the neckline being crossed — whether bearish-to-bullish or bullish-to-bearish — watch for increased volume to be sure that the trend will continue.
Increased volume almost always means increased volatility. Time your investments carefully. Pay attention to catalysts.
Use your stock screener to watch for spikes in volume to help you time your trades, once you’ve identified a breakout.
#5 Stick to the Daily and Weekly Timeframes
Most traders don’t put daily or weekly timeframes to full use.
Don’t be like most traders. Stick to the daily and weekly timeframes. They can help you monitor market activity and make decisions accordingly.
You have to constantly stay informed.
That means consistently using timeframes to monitor your peers’ trading activities.
It’s just one more piece of the puzzle in making safer trading decisions.
#6 Follow News Catalysts
You also need to watch for anything that can move or influence a stock’s price — positive or negative.
Enter news catalysts: another aid to help you predict trends and identify opportunities.
A positive earnings report can be a news catalyst, potentially increasing trader confidence. That confidence can boost prices.
It’s not just earnings reports …
You’re looking for anything that can impact prices and trading activity.
Watch for new product announcements, clinical trials, company mergers, and other news.
Follow reliable news sources to help you identify market trends and spot high-potential trading opportunities.
Are you still here? Great! Then we’ll throw in another bonus step for good measure …
#7 Locate the Best Opportunities with a Stock Screener
Fact: The market won’t wait for you to catch onto trends.
So don’t waste time.
If you want to trade the head and shoulders chart, you need to be able to quickly identify these patterns.
And you need to get in on them quickly. Read: You need a reliable stock screener.
Stock screeners can be your number-one aid. They can help you identify patterns, analyze market activity, and collect data like volume and volatility.
Stock screeners can help you make smart trades.
Let’s be blunt: Every day that you don’t use this tool, you can miss out on trading opportunities.
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The Bottom Line
How reliable is a head and shoulders pattern?
It’s not guaranteed to be profitable — nothing is. But it’s one of the more reliable patterns you’ll see in trading.
The head and shoulders chart is one of the most common and reliable indicators available.
Put it to use to find reversals in both upward and downward trends.
Get to know this pattern.
When you understand what’s happening behind this chart, you’re better primed to take better positions … and well before it’s too late.
Homework time! Watch for the head and shoulders chart pattern while you’re trading. Remember to use an effective stock screener tool and stick to the tips laid out in this post.
Do you trade on the head and shoulders pattern? What do you watch out for? What works for you? Tell us about it! Share your comments.