Every trader interested in technical analysis knows that one of the most powerful reversal patterns of them all is the head and shoulders pattern.
The head and shoulders look to be simple and easy to trade, but yet many traders fail to take advantage of all the strength it shows. The reason for that comes from the fact that its elements are misunderstood and the price action to follow after such a pattern is misunderstood as well.
Being a reversal pattern, it means it will end a trend, either a bullish up (an uptrend) or a bearish one (a down trend), and when it is ending a bearish trend it is being called an inversed head and shoulders.
The pattern is formed out of four elements: two shoulders, a head and a neckline and by the time the neckline is being broken, a measured move confirms the head and shoulders. This means that if the measured move is not completed, most likely the head and shoulders was not present, hence a reversal is not in cards.
Even though there is a widespread believe that price is mandatory to retest the neckline after it is broken but it should be mentioned that such a retest is NOT something that always happens, so trading it is a risky thing to do.
Trading correctly such a pattern implies to look for similarities between the left and the right shoulder as they offer early entries before the neckline is actually broken. In doing that, a trader should look at the amplitude on the left shoulder (the distance price traveled on the left shoulder) apply that outcome on the right shoulder. This gives a better entry price as this market geometry dynamic support/resistance is extremely powerful.
Usually the head of the pattern is a move higher/lower that is quickly retraced followed by a consolidation area for the right shoulder. Because the left shoulder is already in place, we can have an educated guess about the shape and form of the right shoulder and therefore a competitive advantage.
The most important thing to take into consideration here is the time taken for the left shoulder to form, as this gives the moment the trade should be initiated. It means that one needs to actually measure the time taken for the left shoulder to form and apply that measure on the right shoulder. When time expires, it means the range for the right shoulder is completed and the measured move of the whole pattern should follow.
Aggressive traders will look to establish short positions when price is moving into the upper part of the amplitude calculated from the left shoulder, and add to the position after time expires as the fast move lower is about to start.
Conservative traders on the other hand should wait first for the time element to expire and the neckline to be retested for an entry to come but the draw down of this approach is that, like mentioned earlier, a retest of the neckline is not mandatory and the whole reversal therefore may be missed.
By the time the neckline is broken, the measured move comes into play and the way to calculate it is to take the distance price traveled in the head of the pattern and projected lower or higher from the neckline, depending on the nature of the head and shoulders pattern.
This measured move represents basically the take profit for the trade but it should be only a marginal take profit due to the reversal nature of this pattern.
Taking into account the fact that the actual invalidation of the pattern (or the stop loss for the trade) is represented by a move above/below the highest point of the head, trying to enter into a trade as high as possible (in the case of a head and shoulders that forms after a bullish trend) or as low as possible (in the case of an inversed head and shoulders that forms after a bearish trend) is key. It is being said that if price is retracing on the right shoulder more than 61.8% of the distance the head traveled, the whole pattern should be disregarded.
It is wise to exit the trade on the 75% of the projected measured move as in most cases a retracement comes after such a distance is traveled. More cautious traders are exiting even after 61.8% of the distance is traveled in the hope that market is going to go for a new retest of the neckline, but there is no such a rule.
One more thing to consider when it comes to the correct interpretation of a head and shoulders pattern: the bigger the similarities between the two shoulders, the more powerful the pattern is. The same can be said about the time frame that it appears on, as the bigger the time frame, the violent the move to follow.
In terms of Elliott Waves Theory, the head and shoulders pattern can have the head as the fifth wave of an impulsive move or as wave C of a flat pattern, but more on that on the articles to follow at our ForexGator.com learning center.