Head and shoulders pattern

A head and shoulders pattern is a bearish reversal formation. Price makes a high and pulls back, makes a higher high and pulls back to roughly the same area, then rallies a third time and fails to reach the previous high. The trend has stopped making higher highs.

It is one of the oldest patterns in technical analysis. Edwards and Magee described it in Technical Analysis of Stock Trends (1948), and it is read the same way on stocks, crypto, forex and commodities.

• Prior uptrend – the pattern needs a rise to reverse. Without one, three peaks are just a range.
• Left shoulder – a peak in the uptrend, followed by a pullback.
• Head – a rally to a higher high, then a decline back to the area of the first pullback.
• Right shoulder – a third rally that stops below the head, often near the height of the left shoulder.
• Neckline – the line through the two lows between the peaks. It can be flat or sloped, and it acts as support until it breaks.

• Check the trend first: there should be a clear advance into the left shoulder.
• The head must be clearly higher than both shoulders. The shoulders do not have to be equal, but they should be similar in height and width.
• Draw the neckline through the two lows with a trend line and extend it to the right. On Charts, Replay then steps through the pattern candle by candle.
• Watch volume: it is often highest on the left shoulder, lower on the head and lowest on the right shoulder, then rises on the break.
• Wait for a candle to close below the neckline. Until then the pattern is not confirmed.

The head and shoulders trading pattern gives a short trade, and only after the neckline breaks.

• Entry – on the close below the neckline, or on a retest of the neckline from below. Retests are common, but not every break gives one.
• Stop – above the right shoulder. Traders who enter on a retest often place it just above the neckline: the stop is tighter and is hit more often.
• Target – the measured target: the vertical distance from the top of the head to the neckline, projected down from the point of the break.
• Position size – set it from the distance to the stop, not from the distance to the target.

A stock rallies to 130, pulls back to 118, rallies to 146, falls back to 118 and then stalls at 131. The neckline is at 118 and the head is 28 points above it. A close below 118 gives a measured target of 118 – 28 = 90.

The target is a guide to the size of the move, not a level price has to reach. Many traders close part of the position earlier, at the nearest support.

• Timeframe – a pattern built over weeks or months on a daily or weekly chart carries more weight than one on a 5-minute chart.
• Slope of the neckline – a neckline that slopes down means the second low was already lower than the first, which traders read as weaker demand.
• Volume on the break – a rise in volume on the close below the neckline supports the move.
• Gaps – a stock can gap through the neckline on earnings or news. The entry is then far from the stop, and the risk has to be recalculated.

• Selling before the neckline breaks – many patterns never complete, and the right shoulder turns out to be a pause in the uptrend.
• Seeing the pattern everywhere – three peaks in a sideways market are not a head and shoulders. It needs a prior uptrend and a head that stands out.
• Ignoring a failed pattern – if price closes back above the neckline and then above the right shoulder, the pattern has failed. The move up is often fast, because short sellers close their positions.
• Treating the measured target as certain – it is an estimate.
• Mixing wicks and bodies – draw the neckline through the lows of both pullbacks in the same way.