Head and Shoulders Pattern: The Definitive Guide

The Head-and-Shoulders is one of the most common, well-known, and valuable chart patterns that typically appears in an uptrend.

The price does a downside breakout upon the completion of the pattern most of the time.

This generally gives a short-selling opportunity that allows you to profit from the downside movement.

So, in this guide, I am gonna show you the exact processes and methods to help you…

Spot the pattern for a trade setup

Price action confirmation

Stop-Loss Placement

What to do if the trade goes against your favor

And also what you should do if the pattern behaves in an erratic way.

Let’s dive in:

What is a Head and Shoulders Chart Pattern?

A Head-and-Shoulders is a bearish reversal chart pattern that generally forms at the end of an uptrend as a probable result of buying climax.

The pattern keeps trading above a trendline (commonly known as “Neckline”) within a range (can both be compact and large) until it breaks through it to the downside and changes the direction of the market from Uptrend to Downtrend (or Bullish to Bearish).

The pattern consists of three uneven peaks.

With the Head being the highest peak it is surrounded by two equivalent (almost) peaks.

The swing high at the left is called Left Shoulder and the right one is called Right Shoulder.

Together they look like a Head-and-Shoulders portion of a person and hence it’s metaphorically known by this name.

Breaking Down the Formation of a Head-and-Shoulders Pattern

This is how the pattern forms in a typical fashion:

In a strong uptrend, while a stock (or any financial instrument) makes consecutive highs, a moment comes when the buyers get exhausted, and the price takes a downward move.

This makes the Left Shoulder of the pattern.

The Left Shoulder generally forms with high volume

Following that move, the price finds support somewhere around the Bull Trendline and then makes a new high.

However, the downward movement from that new high goes back to the last support zone (last swing low) and breaches the major Bull Trendline.

This makes the Head portion of the pattern.

The Head generally forms with a lower volume.

Now on the third attempt to rise higher, the asset gets the rejection sooner and goes back again to the previous support zone.

This makes the Right Shoulder of the pattern.

The Right Shoulder generally forms with an even lighter volume.

However, the volume pattern is not mandatory.

And there is no such requirement that it must occur in that particular fashion.

How to Identify and Trade a Head-and-Shoulders Top?

The identification of a Head and Shoulders pattern starts with the highest peak surrounded by two smaller peaks of about the same height.

If it’s there…

The next thing is to draw a Neckline (or trendline) by connecting the troughs (or valleys) of the Left and Right Shoulders of the pattern.

The Neckline is used for entry and breakout confirmation.

However, you need to be more flexible while you connect those swing lows of the troughs.

This will help you generate more accurate Sell Signals.

I’ll explain:

As I’ve shown in the schematic (the simplified diagram above) the Neckline doesn’t always appear as a flat baseline.

In fact, most of the time the trendline slants upward (Ascending Trendline) while you connect the adjacent valleys of the Head.

Be flexible while you draw Trendlines.

Here’s a different variation:

If the valley between the Head and the Left Shoulder is deeper than the other (valley between the Head and the Right Shoulder), the Trendline slants downward (Descending Trendline).

Be more flexible while you draw Trendlines.

Moving on…

How to Set Up a Trade for a Head-and-Shoulders Pattern?

You spotted the peaks of the pattern and drew the Neckline…

Now, what’s next?

Wait for the price to break out through the Neckline support and close below it.

When a candlestick closes below the Neckline the pattern gets completed and the breakout confirms.

You should go short on the next candle open, or if this pattern is forming on the daily time frame, you should initiate a short position on the next trading day.

In the following chart of Glenmak Pharmaceuticals, a short entry could’ve been taken on the next trading day (ENTRY CANDLE) followed by the BREAKOUT CANDLE.

The most important thing is that until the price breaks out to the downside by breaching the Neckline, the Head-and-Shoulders pattern will just be considered a continuation pattern to the upside.

So opening a short trade before the price breaks out is meaningless as well as a form of pure gambling.

Now, you might think…

Where to place the Stop-Loss?

And…

Where would I take profit?

Let me explain:

The best place to put your Stop-Loss is just above the Right Shoulder. It minimizes the risk of unnecessarily liquidating your short position.

However, this may not be applicable in every trade.

Some setups don’t give good Risk-to-Reward ratios if you put the SL above the Right Shoulder.

In such cases, you can place your Stop-Loss just above the high of the Breakout Candle.

SIDENOTE: The Stop-Loss can also be placed above the Head but it’ll probably give a horrible Risk-to-Reward Ratio (1:1 or less) if you do so. The only advantage of using this method is that it reduces the chances of your SL being triggered to a great extent (there’s a 90% probability that your SL will not be triggered unnecessarily). To disclaim, I don’t use this method to place Stop-Loss while I trade Head-and-Shoulders tops.

Now, you might be wondering…

How would I calculate the target?

How would I book profit?

I’ll explain:

How to Measure the Price Target of a Head-and-Shoulders Top?

The measuring technique is quite simple.

Take the height of the pattern from the peak of the head to the Neckline using the Trendline tool and place it at the breakout price.

The breakout price is the location of the Neckline at which the candle breaks out to the downside.

Just like this:

If the Head and Shoulders pattern is complex…

The calculation of the pattern height will be like the following chart.

If you manually want to calculate the target…

Take the price difference between the Head and the Neckline. Now subtract the price difference from the breakout price.

As per the technicals, this should be the minimum target.

The question is:

Should you wait for the target to reach?

Is there any guarantee that the target will be achieved?

The answer is:

You don’t need to wait for the target to book profit and there absolutely is no guarantee that the target will be achieved.

Especially if the price is taking too long to reach your target or is consolidating somewhere on the path…

…Consider taking some partial profit and moving your SL above the high of that consolidation range (or a location of your choice).

But as I said at the beginning of this post…

…Sometimes the price may behave in an erratic way which causes you to face difficulties while you trade.

I’ll explain that as well:

Sometimes the Head and Shoulders pattern gets busted.

What does this mean?

This means that the price could go back to the upside without going too deep to the downside.

It causes failure of the pattern.

When the price closes above the HEAD the pattern will be considered Busted.

However, if the price does bounce back after declining more than 10% it won’t be considered Busted.

So, the decline should be less than 10%.

Otherwise, you can’t call such a pattern a Busted.

Feeling quite confident to trade Head-and-Shoulders Tops?

Wait…

There are some rules and caveats on when not to trade such patterns from time to time.

Let me explain:

When You Shouldn’t Trade Head-and-Shoulders Breakouts?

There are a few conditions of the Head and Shoulders pattern that you need to pay attention to before making a trading decision.

The first condition:

When There is a Congestion Zone Nearby.

The congestion zones are compact price action zones (tight trading range) that act as strong Support and Resistance Zones (S/R Zones).

Whenever the price approaches or reaches these zones the market usually stalls.

And there is a higher chance that the price could bounce back from there.

The solution?

Wait for more price action to unfold before you open a new position.

And the best part?

You can go short if the price breaches the support level of the congestion zone.

The second condition:

The Pattern is Too Big.

If the Head-and-Shoulders pattern is too big, stay away from trading such patterns.

The reason is when such a pattern gets too big, on the breakout the sell-off usually is at its peak.

The market becomes oversold.

So there’s a higher chance that your trade would fail.

The solution?

A short-selling opportunity could come on the Pullback or Retest.

If not another pattern will unfold.

The third condition:

The Head is Too High.

If the height of the HEAD is unusually high compared to its adjacent SHOULDERS you should stay away from trading such patterns.

This would look odd and highly disproportionate.

The fourth condition:

The Neckline is Excessively Downward Sloping

If the Neckline of such a Head-and-Shoulders pattern is slanted downward too much, the pattern would not be tradable.

The reason is:

The breakout never occurs.

If somehow occurs the market will probably be oversold by the time it breaks out through the Neckline.

With that:

The market would also probably make a U-Turn around that price level.

Or it could also keep going down.

No one knows. This is just a truth of trading life.

So, you shouldn’t take the risk.

As always…

Wait for more price action to unfold before you initiate a new trade.

How Do You Trade Head-and-Shoulders Patterns?

FAQs