The head and shoulders pattern guides us about trend reversals
The head and shoulders trend reversal pattern
Like any other trend reversal pattern, the head and shoulders formation lets us know when a trend reversal is about to happen. Let us name this formations parts one by one:
- The peak. We can consider this part as one of the shoulders.
- The higher peak. This comes right after the peak, and we can also call this part the head.
- The lower peak. This part is the other shoulder of the formation.
- The neckline. We draw this by connecting the two troughs’ lowest points. The slope can be going up or down. However, a slope going down is usually a more reliable signal than those with slopes going up.
Trading with the head and shoulders pattern
There are times when we can easily spot head and shoulders patterns. For instance, the pattern’s second and highest point is the head. The two shoulders also have peak formations, but they should not be more than the height of the head. We can place entry orders right below the neckline or calculate the head’s high point to the neckline. This distance we calculated is more or less the distance that the price will travel as soon as it breaks the neckline.
When the price travels below the neckline, it moves similar to the distance between the neckline and the head. If it’s not the same, at least it should be close. You can lock in some or all of your profits. You have the option to keep your trade open and hope that the price will continuously move in your favor.
There are also inverted head and shoulders patterns
Inverted head and shoulders patterns are no different aside from the fact that they are reversed or upside down. Instead of a peak, a valley forms that we consider as the first shoulder, followed by a lower valley, the head, and another higher valley for the second shoulder. We can see them form after prolonged downward movements.
If we look at a chart with an inverted head and shoulders pattern, it looks exactly like a head and shoulders pattern — only, it is upside down. We can make entry orders on top of the neckline, or else we can also calculate just like how we did with the head and shoulders pattern. Measure the distance between the lowest part of the head to the neckline. This distance is more or less the distance that the price will travel as soon as it breaks the neckline. Later on, the price will move up once the neckline breaks, and you go home with gains if you reach your target.
Helpful tips to close up the topic
Yes, it is possible to gain some more if the price can keep moving in your favor once the neckline breaks and your target is hit. However, this choice always comes with risk. You can choose to go home and enjoy your profits, but you can also continue and hope for the best if you feel extra confident that luck is on your side.