What are head and shoulders patterns?
Head and shoulders tops and bottoms are reversal chart patterns, which can develop at the end of bullish or bearish trends.
Traders like to trade head and shoulders formations as the price targets are very predictable and the formation has an overall success rate greater than 70%.
What do head and shoulders tops look like?
The head and shoulders top chart formation consists of three peaks, which develops after a strong bullish trend. The first and last peak are approximately the same height and are classified as the shoulders.
The second peak is the highest of the three and is classified as the head of the pattern.
Head and shoulders tops represent the transfer of power from the bulls to the bears.
Please see the below illustration of a head and shoulders top:
What do head and shoulders bottoms look like?
Conversely, the inversion of the head and shoulders top is the head and shoulders bottom.
Instead of peaks, there are troughs. This pattern develops after an extensive bearish trend and represents the transfer of control from bears to the bulls.
Below is an illustration of a head and shoulders bottom:
This is an outline of the inverse head and shoulders pattern. As you see, it is the mirror image of the head and shoulders top.
What is the neck line in a head and shoulders pattern?
Every technical chart pattern has a trigger line, which provides confirmation for entering or exiting a trade.
For the head and shoulders pattern, the trade signal is called the neck line.
When you think about it, this name makes sense, because the neck line is directly beneath the heads and shoulders. Get it?
When we identify a head and shoulders pattern on the chart, the first thing we should do is to draw the neck line.
So, how do we draw the neck line?
The proper way to set up your neck line is to connect the two peaks or troughs (depending if it’s a top or bottom).
Please note the neck line isn’t always flat. If the peak or trough values are slightly different, then the neck line could have a slope.
What do head and shoulders foretell?
To determine the head and shoulders size, you should first set up the neck line.
Then you take the mid-point of the neck line and draw a vertical line connecting the mid-point of the neck line to the top of the head. The distance between the neck line mid-point and the head is the distance we expect the stock to run after breaking through the neck line.
Please note, measuring price targets for head and shoulders tops and bottoms mirror each other. Again, the only difference is the formations are inverted.
How to trade head and shoulders?
When should you open a position?
When you identify your head and shoulders formation, you should start looking for the signal you need in order to enter the market. This signal is the moment when the price breaks through the neck line.
When the neck line is broken, you should open a short position for head and shoulders tops and a long position for head and shoulders bottoms.
Where should you place stop loss orders?
This is a tricky question as traders’ opinions are pretty controversial regarding stop loss placement for head and shoulders patterns.
Some traders claim that the stop loss should be loose and placed on the tip of the head.
A more conservative approach used by traders is to place the stop loss beyond the shoulder peak/trough.
I personally prefer placing the stop loss above the shoulder, as placing the stop above the head provides a 1:1 risk reward ratio.
When should you collect profits?
Again, the rule of thumb for head and shoulders patterns is to determine the price target based on the depth of the head and shoulders pattern.
If this sounds confusing to you, have a look at the image below:
This is a classic inverted head and shoulders scenario. This is the 30-minute chart of Apple for the time frame Jun 4-16, 2015. First, we have a bearish market followed by the creation of an inverted head and shoulders formation.
You can see the neck line, which is represented by the brown line. Once the neck line is broken to the upside, we were able to set our price target based on the depth of the neckline to the trough of the head, which is represented with the black arrow.
After we establish our long position, we place our stop loss below the last shoulder as shown in the image.
After 24 hours, our minimum target is reached and we exit the position after the first bearish candle circled in green.
This inverted head and shoulders formation brings us a profit of $2.20 per share with the Apple equity.
While we exited this position near the target, you should not exit your position if the price continues to move in your favor.
Having fun? Let’s go through another example.
This is the 30-minute chart of Facebook from Oct 25 – Nov 6, 2015.
After a strong downtrend, an inverted head and shoulders pattern develops. Again, we identify the neck line by drawing a brown line across the shoulders.
We open a long position with the first candle that closes above the brown neck line. Meanwhile, we establish our minimum target, which is illustrated with the black arrow.
After a few days, the price reaches our minimum target, but we stay with our long position until our bearish signal develops.
A few hours later, a hanging man develops and we close our long position. From this long position we were able to generate profits of ~ $4.00 per share.
Head and Shoulders Pattern Failure
Although head and shoulders are considered one of the most reliable chart patterns for equity trading, as any other chart technique – it can fail.
Sometimes, we will receive our confirmation signal and the price does not reach our minimum target.
In other cases, the price will confirm the formation by breaking the neck line, and we will see absolutely no movement in our favor. These cases are not rare at all. Thus, I believe we should go through an example of a false head and shoulders signal.
This is the 60-minute chart of Toronto-Dominion Bank, also known as TD Bank. The time frame is May 21 – Jun 8, 2015. After a steady downtrend an inverted head and shoulders formation develops.
We establish the neck line, price target and stop loss, which are best practices for identyfing the formation.
Unfortunately, after opening a long position, TD Bank begins to retreat below the neck line and ultimately trips our stop loss order.
From this position, we accumulated a loss of ~52 cents ($0.52) per share. Although all the symptoms of an effective head and shoulders formation are there, things didn’t work out.
- Head and shoulders tops and bottoms are reversal chart patterns.
- Head and shoulders are one of the most reliable technical formations.
- Head and shoulders is a formation which reverses a bullish trend to bearish.
- Inverted head and shoulders reverse a bearish trend to bullish.
- When we localize a head and shoulders chart pattern, we need to establish the size of the formation, neck line and stop loss.
- Open a position when the price breaks through the neck line.
- Place a stop loss order on the edge of the last shoulder.
- Price target for the formation is equal to the depth of the neck line to the head of the formation.
- When the price target is met, stay with the position until a contrary signal develops.
- The head and shoulders chart pattern can fail.
- Head and shoulders have a success rate of ~ 70%.