The Ultimate Guide to the Head and Shoulders Pattern

Often regarded as the most dependable of all major reversal patterns, amateur and experienced traders alike use the Head and Shoulders chart pattern to bet on the currency and stock markets. The advantage of this chart pattern is that it provides clear zones for setting risk and reward goals.

The inverse (reverse) head and shoulders pattern is just as helpful in any trader's armory as the standard formation and employs the same strategy. The procedure of head and shoulders stock and forex analysis will follow the same logic as described in this article.

How do you define the Head and Shoulders Pattern?

The Head and Shoulders chart pattern is a price reversal pattern that traders use to determine when a trend has reached its conclusion. This reversal indicates the conclusion of an uptrend. The Head and Shoulders pattern resembles its namesake in that it features a distinct 'left shoulder', 'head', 'right shoulder', and 'neckline' arrangement (see image below).

What is the Pattern of Inversed Head and Shoulders? 

The Inverse Head and Shoulders pattern (informally referred to as the 'Reverse Head and Shoulders pattern) is a variation on the normal Head and Shoulders pattern. The Inverse Head and Shoulders pattern is visible during a downtrend (see image below) and signals a trend reversal when higher lows are formed.

How to Recognize Head and Shoulders Patterns on Currency and Stock Charts

Recognizing the Head and Shoulders pattern on forex and stock charts requires the same steps, making it a highly adaptable tool to incorporate into any trading strategy. The following list summarizes the critical steps involved in recognizing this pattern:

• Determine the market's general trend by examining price movement and technical indicators (preceding uptrend)

• Isolate the creation of the Head and Shoulders chart.

• The 'Head' and 'Shoulders' should be as near to equidistant as feasible.

• Define the neckline at the lowest position between both'shoulders' – horizontal is preferable but not required.

These steps apply to both conventional and reverse head and shoulders designs.

How to Use Head and Shoulders Patterns in Trading

Once a trader understands the normal and inverse head and shoulders patterns, it's quite simple to apply them to technical analysis in both the forex and equities markets.

Stocks Trading 

On the Germany 30 (DAX 30) stock index, the chart above depicts a Head and Shoulders pattern. The pattern's development is obvious, with the dashed blue horizontal line highlighting the neckline. Traders will take a short position upon a confirmation close below the neckline, as indicated by the 'ENTRY' label on the chart or by the pip movement below the neckline. Certain traders adhere to the 'two-day' closure rule, which requires a second confirmation candle to close below the neckline prior to initiating the short trade. Trading on the pip break below the neckline enables traders to profit from the whole move down, but this strategy is riskier because the breakout below the neckline is not verified by a candle closure.

To determine stop and limit levels, there is a common rule of thumb. By subtracting the 'right shoulder's' high point, the stop level is specified, while the vertical distance between the neckline and the 'head's' high point approximates the limit distance – 1832.8 pips in this example. This trade's risk-reward ratio is around 1:1.2, which is within DailyFX's suggested risk management criteria.

Forex Trading

On the USD/ZAR forex pair, the Inverse Head and Shoulders pattern above demonstrates an unbalanced structure that is extremely prevalent in most formations. The neckline is somewhat misaligned, but yet maintains the pattern's integrity.

The long entry level is defined by the break of the neckline or the close of the price candle above the neckline. The stop distance is measured from the 'low' to the 'right shoulder,' whereas the limit distance is determined from the 'head' low to the neckline. 

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