The Head and Shoulders Strategy

A head and shoulders, often shortened to H&S, is one of the most

recognized and most popular trading formations. Together with the inverse
head and shoulders pattern (IH&S), these two represent arguably the most
effective reversal patterns.

Both patterns are powerful reversal formations that offer a very attractive
risk-return ratio. On the other hand, they are not very common. Hence,
once spotted, they become extremely effective.

In this trading guide, we discuss:

● The key characteristics of the head and shoulders and inverse head
and shoulders patterns;
● Pros and cons of the head and shoulders and inverse head and
shoulders patterns;
● How to identify and correctly draw these two patterns;
● Effective trading strategies based on head and shoulders formations.

Characteristics

You must be wondering why it is called a head and shoulders formation.

The answer lies in the fact that this pattern resembles a baseline with three
peaks. The center (the head) is the highest peak and it is neighboured by
two lower peaks of identical height (shoulders). This way, the formation
resembles its namesake - a ‘left shoulder’, ‘head’, and ‘right shoulder’.

A head and shoulders pattern (Source: LuckScout)

Before we start discussing the formation in detail, it’s important we note the
difference between a head and shoulders pattern and the inverse head and
shoulders. The former is a bearish reversal pattern that helps the sellers
retake control and end the bullish run. As such, it takes place at the top of a
pattern.
Conversely, the latter is a bullish reversal formation that facilitates the end
of a downtrend. The buyers are able to reverse the trend direction and
push the price movements in the opposite direction. As a bullish reversal
pattern, it occurs at the bottom of a chart.

An inverse head and shoulders pattern (Source: dailypriceaction)

There are three mandatory characteristics of these two patterns. Both

consist of three mandatory elements:
 1) Head - In the H&S pattern, the head represents the highest center
peak. In the inverse version, it’s the lowest low;
2) Shoulders - Two shoulders are peaks/lows that sit on both sides of a
peak. In an ideal scenario, these two are symmetrical - at the same or
near the same price level and height compared to the peak. However,
a vast majority of all H&S and IH&S formations are based on
asymmetrical shoulders;
3) Neckline - This is arguably the most important element of a structure.
A neckline connects the lowest/highest points of two shoulders to
create a “make it or break it” line. A break of the neckline activates
the patterns.

Pros and cons

As noted above, both head and shoulders and inverse head and shoulders
are effective reversal patterns. This is exactly their greatest strength - the
efficiency. Given the structure under which they operate, a neckline
provides us with clearly defined entry and exit levels.

As a consequence, these two patterns usually offer a very attractive

risk-reward ratio. This is why traders tend to spend a significant amount of
time and resources identifying potential (inverse) head and shoulders
patterns.
And this is exactly why these patterns are limited. They are quite scarce
and one has to browse financial markets to identify these two. Unlike some
other reversal patterns, the (inverse) head and shoulders formations are
more rare.

Head and Shoulders Trading Strategies

Trading the head and shoulders pattern

After we’ve gotten more familiar with these two patterns, we will now see
how to identify, draw, and ultimately trade the head and shoulders
formations. In a chart below, we see USD/CAD trading higher in a
continuous uptrend.

As noted above, the head and shoulders pattern is a bearish reversal

formation that occurs at the top of the chart. Hence, the first step in
identifying this pattern is to look for uptrends. Once this is completed, we
move to look for patterns that resemble the head and shoulders formation
with three peaks.
 Identifying and drawing head and shoulders pattern - USD/CAD daily chart (Source:
TradingView)

In the USD/CAD daily chart here, we clearly see the highest peak in the
center, preceded and followed by two other tops of similar height. Finally,
the diagonal trend line connects two of the lowest points of two shoulders
to create a neckline.

Up to this point, we only have a “draft” head and shoulders pattern. The
formation becomes active once the neckline is broken, and the sellers force
a close below the neckline. Once this takes place, we move onto the phase
of trading the head and shoulders pattern.
The neckline provides us with a level to play against. There are generally
two accepted options to determine where the entry should be placed. The
first option offers traders a chance to sell as soon as the neckline is broken
and a close below the broken neckline is secured.

The second option is a safer approach. You should only sell the financial
instrument when the price action closes below the neckline and then
performs a “throwback” - the retest of the broken neckline from the lower
side.

By using the former option means that you can’t miss a trade. You are in as
soon as the close below the neckline is secured. However, it is less
profitable as your entry may come significantly lower, hence stop-loss order
will be far from the entry

The latter option is much better in this regard as the associated risk is very
limited. The entry usually takes place at the neckline itself, hence the stop
loss order is very close to the entry. However, no one guarantees you that
a throwback will take place, meaning that the price can simply resume
lower until it reaches the completion point.
 Trading the head and shoulders pattern - USD/CAD daily chart (Source: TradingView)

In this particular case, we see that both options have been ultimately
presented to us. You can choose which option you prefer based on your
trading style and risk management. In both cases, the stop loss order is
placed just above the neckline, allowing some space for the price to briefly
trade above the neckline.

With the option 1, your entry would be at $1.2805. The other options would
have your entry around $1.2840. The neckline comes closer to $1.2850,
hence our stop loss is placed around 1.2870.
A take-profit order is calculated by copying the distance between the head
and a neckline and pasting it lower, starting from the point where the
neckline is broken. The end point provides us with a take-profit order, in
this case it is around $1.2530.

Therefore, a trader is risking 65 or 25 pips to make 275 or 315 pips, an

incredibly profitable trading setup.

Trading an inverse head and shoulders pattern

Similarly, we apply the same methodology to trade the inverse head and
shoulders formation. Once the downtrend is identified, we search for a
bottom where the center low represents the lowest point.

In this particular case - NZD/USD - the center low is a rounded bottom.

Next to it, we have two higher lows on each side, representing shoulders.
Finally, the neckline connects the highs.
Identifying and drawing an inverse head and shoulders pattern - NZD/USD daily chart (Source:
TradingView)

As you see on the right shoulder, NZD/USD created a false breakout. It is

exactly for this reason that it is advised to wait for the price to close above
the neckline before taking a position in the market.

The breakout occurs in a strong fashion with the price bursting through the
resistance. Unlike in the first case, this time we are left without the second
option as no throwback has taken place. Hence, if you had waited for the
retest to enter a trade, you’d be left without a position in the market. The
neckline comes around $0.64300.
The first entry option means you are inside, but look at how far from the
neckline the breakout candle closed. This means your entry is at $0.6500,
around 70 pips from the neckline and approximately 90-100 pips from the
stop-loss.

Trading the inverse head and shoulders pattern - NZD/USD daily chart (Source: TradingView)

Despite the higher risk, a long distance between the bottom and the
neckline means that the profit-taking order is also very attractive. The end
point comes at $0.6665, which is around 165 pips from the entry. All in all,
your risked 90-100 pips to gain 165 pips. Unlike the first scenario, this one
offers a standard risk-reward ratio of close the 1:2.
Summary

● The head and shoulders pattern is one of the most popular bearish
reversal patterns due to its efficiency and increased focus on the risk
tolerance;
● The inverse head and shoulders formation is the head and shoulders
turned upside down. Thus, it is a bullish reversal formation that helps
the buyers reverse the trend direction from a downtrend to uptrend;
● The greatest advantage of the head and shoulders pattern is that it
clearly defines levels for setting stop loss and take profit orders;
● Its biggest limitation lies in the fact that it is not a very common
pattern to find.