What Is a Head and Shoulders Pattern?

What Is the Head and Shoulders Chart Pattern?

The head and shoulders pattern, also known as H & S is a chart formation that signifies an upcoming bearish reversal. Structurally, the pattern has a resemblance to three inverted Vs or Cones in close succession. The middle Cone always has a higher peak than the left and right cone-like structures.

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While no chart pattern turns in profit with 100% accuracy, the H & S pattern is relatively reliable. Admittedly, the pattern is more noticeable in some cryptocurrencies than others. The longer a crypto asset has existed, the higher the chances of spotting many heads and shoulders on its chart. That explains why Bitcoin is the cryptocurrency with the most head and shoulders patterns on its chart.

Elements of the Head and Shoulders Pattern

The following elements can be found on the head and shoulders chart pattern.

• Left Shoulder – The left shoulder is the first element of the H & S pattern. It can hardly be identified before the other parts of the pattern are formed.
• The Head – The head is the peak of the structure and has the highest price level.
• The Right Shoulder – The right shoulder is the later part of the structure. The formation of the right shoulder gives a clearer picture of the structure of the pattern.
• The Neckline – The neckline is not part of the candlestick formation. It is a line drawn by traders to easily identify sell entries on the chart.

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How to Trade the Head and Shoulders Pattern

The head and shoulders pattern is one of the most reliable chart patterns. It is quite easy to trade. Technical analysts identify potential regions for entries on the pattern before opening a sell position. They also identify potential levels of price invalidation. This helps to cut down losses when the trade doesn’t go as planned. To trade the H & S pattern, you need to identify your entry, your stop loss, and your take profit levels.

The Entry

There are two ways to enter the trade. Traders may create a sell order once the neckline is broken and a candle closes below the neckline. It’s safer for traders to confirm a close beneath the neckline before opening a sell position.

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The second way to open a position is by waiting for a retest of the neckline. For a lower-risk entry, traders could combine candlestick patterns and the volume indicator. A bearish candlestick spotted at the neckline could lay grounds for a more accurate sell entry.

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Setting Your Stop-Loss

To minimize losses, some technical traders set their stop-loss (SL) between the neckline and the peak of the right shoulder. Although this makes it easier for the trader to be taken out, it minimizes potential losses.

A more objective way to set the stop loss would be placing it right above the peak of the last high, that is, the right shoulder. Doing this reduces the chances of getting stopped out, but also increases the loss by 2x compared to the conservative way.

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Setting your Take-Profit

The take-profit level depends on the length of the uptrend before the reversal. The longer the uptrend, the larger your take-profit (TP) could be. It is advisable to set your TP before the start of the uptrend.

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Expert traders never set their SLs and TPs randomly. Support and Resistance levels are used to determine where to set these. Additionally, some expert traders set their take profits at varying key levels on the chart. This helps to prevent complete loss should the market take a U-turn.

Traders also trail their profits to benefit maximally from the trend. From the image above, it is evident that a trader who decides to take profit too early would not benefit maximally from the downtrend that followed the head and shoulder pattern.

The Psychology Behind the Head and Shoulders Pattern

The formation of this pattern can be traced back to the psychology of market cycles. The formation begins when the market has been bullish but is close to the end of its uptrend. Typically, a smooth bullish run is accompanied by higher highs and higher lows on the chart.

The bullish momentum of a cryptocurrency or any other asset will eventually come to an end. The left shoulder is formed, followed by the head, which is a higher high, and with an equal or almost equal low with the left shoulder. After the equal low is formed, bullish traders spot that as an opportunity to enter the market again. This further pushes the price of the cryptocurrency up, but not so much.

The bulls gradually lose control as they fail to break the previous high or the head of the chart pattern. At this point, the bears come in. The bears activate their selling orders which send the price back down. The selling pressure causes the price to break the previous support or equal lows that have been formed.

In some instances, the selling pressure could be so intense that the price of the asset fails to retest the neckline before plunging further. In some other cases, the neckline could be retested, and more sellers place sell orders upon the retest.

To get the best out of the head and shoulders pattern, technical traders may use the structure in harmony with trade volume. When the neckline is broken, and the bulls’ trade volume diminishes, that’s a good sign to short the market.

What Is the Inverse Head and Shoulders Pattern?

The inverse head and shoulders pattern is the opposite of the head and shoulders pattern. The inverse H & S pattern is used for spotting bullish trend reversals. It also consists of a head, a right shoulder, and a left shoulder. The neckline can be used too for identifying entries more accurately.

The inverse head and shoulders pattern is formed when the market has been on a downtrend. At some point, the bears lose control, selling pressure reduces, and the bulls take over. Buy entries could be executed immediately after the neckline is broken or after the neckline is retested. It should be noted though that not all breaks are retested.

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Advantages of the Head and Shoulders Pattern

The head and shoulders pattern has the following benefits:

• The head and shoulders structure is distinct and can be easily identified on the chart. For novice traders, switching from candlesticks to a line chart can further make this pattern easier to identify.
• The H & S pattern can be used with any cryptocurrency. Bitcoin, Ether, Gate token, and so forth. It can also be used to trade Forex, Stocks, and Commodities.
• It is one of the most reliable reversal signs for technical analysts. It is also utilized by many retail traders.
• The pattern can turn in large profits for big market movements or long downtrends.

Disadvantages of the Head and Shoulders Pattern

The head and shoulders pattern has the following disadvantages:

• Whales or market makers sometimes capitalize on this pattern to grab liquidity from retail traders.
• The stop loss could be relatively far, leading to a significant loss if the market fails to continue trending downwards.
• It takes a lot of time to confirm the structure of the pattern and possible reversal. The formation of the left shoulder and head could be lengthy, especially on larger timeframes.
• Just like any other chart pattern, the head and shoulders pattern could fail sometimes. No trading pattern is 100% reliable, and the H & S pattern needs to be used with the other reversal indicators or technical tools.

Conclusion

Undoubtedly, the head and shoulders pattern is an effective chart strategy used in technical analysis. Interestingly, it is easy to learn and implement. The best way to master the head and shoulders pattern would be to practice and backtest. Backtesting helps traders filter the noise and uncover difficulties that cannot be found theoretically. Once you’ve learned the pattern, backtest on as many timeframes as possible. Then use the information gathered to make trading decisions.