Learn To Identify & Trade The Head & Shoulders Pattern Properly.

BITSTAMP:BTCUSD   Bitcoin / U.S. Dollar
Head & Shoulders Pattern

1. Introduction
2. Definition
3. Qualities
4. Example
5. Conclusion

1. Introduction

I realize the Head & Shoulders pattern is a common pattern most traders know. However, I feel that too many traders don't identify them properly nor realize the actual makeup of a H & S.

There are two types of Head & Shoulders: Inverse, and regular.

According to accuracy for the Head & Shoulders Pattern is 83.04% & Inverted Head & Shoulders Pattern is 83.44%. In crypto though it may be lower due to volume volatility . For this educational idea I am using an old example of a H & S and will be only providing examples for a bearish H & S. The same rules apply for a inverse. I am quoting sites here that I will link.

2. Definition

A Head and Shoulders reversal pattern forms after an uptrend, and its completion marks a trend reversal. The pattern contains three successive peaks with the middle peak (head) being the highest and the two outside peaks (shoulders) being low and roughly equal. The reaction lows of each peak can be connected to form support, or a neckline.

As its name implies, the Head and Shoulders reversal pattern is made up of a left shoulder, a head, a right shoulder, and a neckline. Other parts playing a role in the pattern are volume , the breakout, price target and support turned resistance. We will look at each part individually, and then put them together with a example.

3. Qualities

  • Prior Trend: It is important to establish the existence of a prior uptrend for this to be a reversal pattern. Without a prior uptrend to reverse, there cannot be a Head and Shoulders reversal pattern (or any reversal pattern for that matter).

  • Left Shoulder: While in an uptrend, the left shoulder forms a peak that marks the high point of the current trend. After making this peak, a decline ensues to complete the formation of the shoulder (1). The low of the decline usually remains above the trend line , keeping the uptrend intact.

  • Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline (2). The low of the decline usually breaks the uptrend line, putting the uptrend in jeopardy.

  • Right Shoulder: The advance from the low of the head forms the right shoulder. This peak is lower than the head (a lower high) and usually in line with the high of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack. The decline from the peak of the right shoulder should break the neckline.

  • Neckline: The neckline forms by connecting low points 1 and 2. Low point 1 marks the end of the left shoulder and the beginning of the head. Low point 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two low points, the neckline can slope up, slope down or be horizontal. The slope of the neckline will affect the pattern's degree of bearishness—a downward slope is more bearish than an upward slope. Sometimes more than one low point can be used to form the neckline.

  • Volume: As the Head and Shoulders pattern unfolds, volume plays an important role in confirmation. Volume can be measured as an indicator (OBV, Chaikin Money Flow ) or simply by analyzing volume levels. Ideally, but not always, volume during the advance of the left shoulder should be higher than during the advance of the head. This decrease in volume and the new high of the head, together, serve as a warning sign. The next warning sign comes when volume increases on the decline from the peak of the head, then decreases during the advance of the right shoulder. Final confirmation comes when volume further increases during the decline of the right shoulder.
  • Neckline Break: The head and shoulders pattern is not complete and the uptrend is not reversed until neckline support is broken. Ideally, this should also occur in a convincing manner, with an expansion in volume.

  • Support Turned Resistance: Once support is broken, it is common for this same support level to turn into resistance. Sometimes, but certainly not always, the price will return to the support break, and offer a second chance to sell.

  • Price Target: After breaking neckline support, the projected price decline is found by measuring the distance from the neckline to the top of the head. This distance is then subtracted from the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should be considered as well. These factors might include previous support levels, Fibonacci retracements, or long-term moving averages.

    As full disclosure parts 2 and 3 are heavily quoted from:
    They have worded their explanation to my agreement.

    4. Example

    On the main chart above we have the 45 minute from April 2nd to the 4th.

    Without going over each point placement, (which I will do in a video linked at the bottom of this post) let's take a look at the make up of this H & S.
    First the volume make up of the formation, I feel this is the error traders make when trying to identify them, they never look at the Volume metrics. Below we have the Chaikin Money Flow & Chaikin Oscillator on.

    We see the following Volume confirmation needed to identify a H & S:
  • Volume spike running into the L Shoulder formation.
  • Decrease in Volume into the head formation.
  • Spike coming out of the head top. (This identifies a Bull/Bear struggle)
  • Decrease into the formation of the R shoulder.

    Looking at the bottom of that chart we see the C.M.F. OSC confirming this as a general trend.

    Lets say this is happening in real time. We would measure the distance between the Neckline and Head to find our exit target.

    We show a 3.4% range, so we would take the Neckline and measure the same distance from there as show below.

    Now as can be seen we dropped further than that. At the time there was a few other factors at play, which as mentioned above in the Price Target definition there is always other factors to consider. But just trading this blindly, and with H & S rules that is where we would set out Take Profit.

    Clearly in a real time situation everything is different, but in order for this trade to be executed properly and safely we would let the entire formation form and enter into a short on the Neckline break. We would then immediately set a stop loss above the Right Shoulder as can be seen below. Which leads me to my conclusion....
Comment: 5. Conclusion

Trading the Head & Shoulders Pattern has a few issues. One is, you must let it form before calling it, this is where most traders mess up. Another is it is very common to see a Neckline break, then a retest of that Neckline. Traders open positions and then immediately see a Neckline retest scaring most inexperienced traders out of their position. USE a stop loss and practice discipline when trading this, the stop loss is there for a reason so let it hit, otherwise trading is not for you if you cannot stomach getting stopped out. You’ll learn that patience is the key for trading head and shoulders patterns.

There needs to be a specific Volume make up for the H & S to actually be a H & S. The psychology and makeup of a H & S cannot exists without that. Verify this always as the H & S is forming and also before entering the neckline break

Here are a few rules I like to use additionally:

  • Give more truth to a head and shoulders pattern with a upsloping neckline.

  • When the right shoulder is lower than the left shoulder, consider it a sign of higher profit potential.

  • Some traders get stuck on perfectly formed H & S. They think of symmetrical patterns as superior, crypto trading is far from symmetrical, symmetrical looking patterns typically perform worse.

  • The neckline break should occur with a volume spike. You can see the volume surge with the help of a volume indicator like the OBV or C.M.F..

  • As I said previously, always, always let a H & S confirm before entering, it is dangerous to open the position without it forming and breaking the neckline.

  • It’s important to look for significant support that might impede the falling momentum. Check if a strong support exists between the head and shoulders pattern and the target.

    The H & S formation is a very good formation to learn and spot. BUT what is even more important is properly identifying it, use this guide as a study for identifying them.

    Thank you for reading and please support by clicking like on this analysis. Do the same for the video link below! Like, follow, share and interact to help me stay motivated to keep these trending. Thank You! :)
Comment: Video Version of this is available here below

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