The head and shoulders chart pattern is among the more elaborate chart analysis patterns. While some are easier to detect and draw, this formation has a higher degree of detail. The big picture of it looks like an extended mountain ridge. But in actuality, it forms something akin to the head and shoulders pattern that it is named after.
The Head and Shoulders Pattern: A Closer Look
In technical analysis, the more chart patterns you know the better. Although some traders tend to stick to a group of patterns that work well for them, the more the better. These are the tools in your arsenal of analyzing the chart.
One of these really important patterns is known as the head and shoulders pattern. The main aim and target of this pattern is to indicate the coming of a reversal from bull to bear market.
The reason this pattern is known as head and shoulders is because it is formed out of three highs. These three highs form the base line of the pattern. But they are not at the same height. The middle high point stands higher than the two side highs, thus forming the center “head” part of the pattern.
As such, the side highs stand at almost exactly the same height, thus giving shape to the two “shoulders” of the pattern.
The exact formation of this pattern is when the price of a forex trading pair, or any other financial asset, rises higher to hit the first high after which it will decline to a degree. Then following the decline, prices will rise again, this time higher than the previous high to form the head. Then the process is repeated and we can expect a decline followed by another high point that is lower than the previous high, which will form the second shoulder. After the second shoulder is formed, prices fall back down again, this time much harder in order to confirm the coming of the bear market.
Among the many trend reversal patterns, the head and shoulders pattern is regarded as one of the most dependable indicators, as traders can be assured that the reversal in the trend is forthcoming.
More Details About the Head and Shoulders Pattern
So as we discussed the head and shoulders pattern is made of three peaks or three high points. And it is used to indicate the coming of a bearish trend. In fact, it is the reversal of a bullish trend toward a bearish trend that is indicated by this pattern.
As you might have guessed, with the head and shoulders, the highest peak will form the new resistance level which will not be broken. This new resistance level should be a good indicator for traders that it is the highest prices will go for a while.
Interestingly, there is another type of head and shoulders pattern which is known as the inverse head and shoulders pattern. The inverse head and shoulders pattern stands in exact opposition to its counterpart. In that it is an indicator used to predict the coming of a reversal trend from bearish to bullish. But we will go into more detail of the inverse head and shoulders in the next part.
The Inverse Head and Shoulders Pattern
If you are a seasoned trader you already know this, but even if you are new to the game it might be an interesting fact to know that most of the technical indicators have a twin that is their exact opposite. Such as the rising or falling triangle patterns. The same is true with the head and shoulders pattern. The opposite is called the inverse head and shoulders pattern.
The inverse head and shoulders pattern is a trend reversal indicator that is used to indicate the reversal of the bearish trend into a bullish one.
The way it is formed is through three low points that together form the base line of the pattern. At first the prices begin to fall to hit the first low point. Then they rebound and compensate a little bit but then they fall down harder to hit the second low point, which is lower than the other two and forms the inverse head. Next, the process is repeated to hit the third low forming the second inverse shoulder. After the whole pattern is formed prices will shoot up toward the bull area.
Along similar lines, with the inverse head and shoulders pattern the inverse head, which is the lowest point in the pattern, is considered as the support line as it is the lowest prices will fall for that period.
How to Trade with the Head and Shoulders Pattern?
The main head and shoulders indicator is a sign that prices are going to drop sharply. When three peaks are recorded, with the middle one standing higher than the other two, then traders take it as a strong sign that a sharp drop is coming. Naturally this provides an opportunity for the traders to go short. With a short position they can sell their position before prices fall down further.
On the other hand, with an inverse head and shoulders indicator, when the three low points are seen by the traders where the second low stands lowest of all, then it provides a reliable sign that prices are going to recover to a great degree very soon. In fact, it is not just a sign of price recovery, but in fact the coming of a bullish trend. Of course, in this scenario, traders would be advised to take a long position and place their bets in the market to stake their claim of the asset before prices get too high for them. So they can buy low at this point and then sell higher if they want when eventually prices increase.
The head and shoulders pattern is considered one of the favorite patterns among the most seasoned traders. However, it might be a little bit difficult for novice traders to detect.
On other hand, the head and shoulders pattern provides traders with precise target goals so they know what they are supposed to hit in order to have maximally profited from the trend reversal. At the same time, this indicator provides data regarding when to stop or more precisely stop loss.
All in all, both the head and shoulders and its inverse version are quite reliable trend reversal patterns that can help forex traders benefit from trend changes in the market.