How to trade head and shoulders pattern

 

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Overview

Head and shoulders pattern is one of the most reliable yet misunderstood chart patterns in the technical world. The name comes from the way pattern looks like a head with two shoulders. It is a reversal pattern, which signals the security is likely to move against the previous trend. There are always two patterns for head and shoulders pattern. The first one usually occurs at the top of the market and is a signal to the customer that the security price is about to fall once the pattern formation is complete. It is usually formed at the top end of an upward trend. The second version inverse head and shoulders, which form at the bottom, signals that a security price is one the rise. It is usually formed at a downward trend. Both of them have similar construction, where there are four main parts, two shoulders, a head, and a neckline, which is formed once the second shoulder is formed.
Head and shoulders are set of peak and trough and neckline offers the support. It is formed on the basis of Dow Theory. The upward trend is a period of successive peak and trough rise. The downward trend is a seen as a period of falling of peak and trough. The pattern is an indicator of a weakening in a trend same like deterioration in peak and trough.

Formation

Left shoulder of the pattern is formed by a price rise followed by a decline. This peak will be the highest left peak in the pattern. Head is formed when the price goes up again and will form the highest peak of the pattern. Right shoulder occurs after a decline in the price, followed a rise, which will result in the formation of right peak. it is lower than the head. As the formations are never perfect, there will be much noise surrounding and in between head and shoulder.

Inverse Head and shoulder

As said earlier, they form at the market bottom. Left shoulder will see a decline of price and then a rise and fall again. This will form left shoulder. Head is formed when the price rise one it the rock bottom of the pattern.

Pattern

 

Head and shoulders pattern up

Right shoulder is formed similarly to left shoulder. The price will rise and then fall again but not as low as head. There is a chance of seeing noises in between the head and both shoulders because the formation once again is not perfect.

Finding neckline

Identify left shoulder, head and right shoulder on the chart. In head and shoulder pattern top, we will connect the low right after the left shoulder is formed with the low once the head is formed. This is the neckline of the chart. In a reverse pattern, we will the high formed following the formation of left shoulder to the high of formed right after the head.

How trader can use the pattern

First of all traders need to wait till the pattern is complete. You can’t assume that pattern will develop or a pattern that is already developed to complete in a near future. If there is any partially developed or nearly completed pattern, then it should be watched but no trades should be made until it break the neckline. In the head and shoulders, we will wait for the price to go down than the neckline after the peak of the right shoulder. And in inverse head and shoulder we will wait for the price to go up above the neckline once the formation of the right shoulder is completed. Once the pattern is complete, you can start the trade. Keep a note of entry, stop and profit target. And not the variables that have any effect on your stop or profit target. Most common entry is made when the neckline is broken and a trade is taken. Another entry comes with more patience, but there is a chance of missing the entire move. In order to make this move, you need to wait for a pullback to neckline once the breakout happened.

Placing your stop

You place the stop at the right shoulder in a top pattern. You can use the head of the pattern as a stop, but it involves more risk. In the inverse pattern, the stop is below the right shoulder. Setting up profit target. Profit target is the difference between head and low point of either shoulder. The difference is then subtracted from neckline breakout level at the market top to give you the price target. For the bottom, difference and neckline breakout price are added to get the price target.

How this pattern works

When the price falls from market high, the trend of aggressive buying will reduce. When it reaches the neckline, the people who bought at the peak right shoulder will face the prospect of large loss. This is driving the price close to profit target. In the inverse pattern, as the volume expand the breakout occurs. This will increase the interest in buying. This will drive the price towards the target.

 

Latest Head and Shoulder Pattern in Nifty

 

nifty head and shoulder pattern

A classic example of head and shoulder(H&S) formed in Nifty in this year itself during April month. From the picture above you can see there is a formation of Left Shoulder(LS) at 8996.6 on 30th Jan, formation of Head at 9119.2 on 4th March and formation of Right Shoulder(RS) at 8844.8 on 15th April. A neckline broken around 8167 somewhere at the end of April which confirms the head and shoulder pattern in nifty.

Take a note on volume during these points on RSI indicator. RSI crossed the topline in LS but failed to scale up to the same level during Head formation though nifty reached higher levels than LS. You can see a significant decline in RS than LS and Head which is a perfect Head and Shoulder Pattern.

After the confirmation of H&S a target can be calculated for a Short position. Draw a line between head and to the neckline – which is 9054-8371=683 points. So, you can assess the target by deducting 683 from 8371 which comes to 7688 which is achieved on 25th August.

Lastly let us see how a head and shoulder pattern can fail. See the following picture which indicates the failure in H&S pattern.

failed Head and Shoulder

From the picture above you can see H&S pattern can be failed once the head level is breached. From the nifty H&S picture above you can see such attempt by Nifty during July month but finally failed to cross at least RS level at 8844 and ended up reaching the target at 7683-7688 during August.