The use of patterns in trading has been among the best ways to improve one’s chances of making profits – and among the most sought-after patterns today is the Head and Shoulders pattern. This pattern is famous because it has a high tendency to signal a trend reversal. It is easy to spot in a chart because of its distinct characteristics which compose of a high peak in the middle (which makes the head), and two lower peaks of almost the same size on both sides (which makes up the two shoulders).
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So, what is a Head and Shoulders Pattern?
Among the few chart patterns that have a good success percentage with regards to signaling a reversal is the Head and Shoulders Pattern. It is a strong chart formation that appears with a common baseline or lower trend line among its head and two shoulders on each side. The head has the highest peak while both shoulders have lower peaks that touch a common upper trend line.
Compared to other chart formations or patterns, this pattern can take time to completely mature or develop (from a few months to years) and is prominent only on the top or bottom of a trend. One of the main reasons why it also takes time to develop is because it needs to reach the top or bottom of the trend where price action is most volatile. On that note, if the formation is located in the middle of a trend or during consolidation, there will be great chances that the breakout will fail.
The head and shoulders pattern is drawn by creating a neckline that connects all bases of the head and both shoulders. The height of the head should always be taller than either of the shoulders. Both shoulders should have almost the same height and should never be greater than the height of the head.
Breakouts for a head and shoulders pattern happen whenever the line connecting all bases are breached by the recent price. Usually, a considerable volume or thick candle will confirm the breakout.
The counterpart of the head and shoulders pattern is the reverse head and shoulders pattern. It basically has the same characteristics however is arranged in reverse formation. The head and shoulders pattern works in steep bullish markets while the reverse head and shoulders work in bearish markets. Again, be mindful however that the head and shoulders along with the reverse head and shoulders pattern are used best when located at the end of a trend.
So, if you’re looking at a bullish market, finding the head and shoulders pattern at the end of the trend would be a great way to secure your investment seeing that a reversal will be anticipated. On the other hand, if you’re dealing with a bearish market, the reverse head and shoulders pattern would be your best signal to a change of trend from bearish to bullish – this would be a great time for you to secure positions.
How to implement the head and shoulders pattern on eToro
Now that you have a good idea of what the head and shoulders pattern is and how to find one in a chart, let’s see how we can implement it on an actual trade on eToro and what would be the best steps to take once faced with such pattern.
The image below shows a chart for Overstock.com showing a head and shoulders pattern formed from the last month of 2018 and early 2019. We can see here from the left side of the chart that the market is bullish (going up/uptrend) and had a trend reversal right after forming a head and shoulders pattern.
In this illustration, a neckline was drawn by connecting the legs of all the components – namely the head and 2 shoulders. Also, we can see here that the shoulders need not necessarily be of exact same height as each other. What’s important is that both shoulders should have a peak that is shorter than the head and all bases must fall on the same line.
With this example, we can see the increased volatility of the market within the specified range or period. The head and shoulders pattern is a bearish chart indicator which means it signals the time when prices will drop. In this case, the arrow on the right part of the pattern (pointing towards the base that touches the neckline) would be the best exit point to avoid considerable losses.
As we can see after the pattern has been formed, the trend continues to move at a downtrend.
For the reverse head and shoulders pattern, let us refer to the stock CRBP (Corbus Pharmaceuticals Holding). In this example, a reverse head and shoulders pattern formed around the third quarter of 2019. We can notice here that the pattern developed at the end of a bearish trend and reversed to a bullish trend. The reverse head and shoulders are also made of a head that has the highest peak and two shoulders with lower peaks. All components fall on a single baseline which serves as the neckline of the pattern. The breakout happened as soon as the neckline was breached from the last leg on the right of the pattern.
For a reverse head and shoulders, the best buy point or entry point is always around the right shoulder with its last leg breaching the neckline. After which, we can see that the trend continued to an uptrend.
From these two particular examples of the head and shoulders and reverse head and shoulders pattern, we can point out a few considerations which can help you make sure that you’re dealing with the right pattern. First is that it developed within at least 3 months – this means patience is a virtue when handling this kind of pattern. It usually takes longer to develop compared to other patterns because it is at the end of the trend – as mentioned earlier. At the end of each trend, many position holders are still fighting to keep the trend going thus making the price movement volatile at this stage.
In addition, both head and shoulders and reverse head and shoulders pattern breakout from the neckline using a thick volume. More often than not, a thick long candle will break the neckline for a breakout.
The head and shoulders pattern is really the most sought-after pattern in a chart by many traders because not only is it easy to find because of its familiar form but because it accurately points out the exit and entry points in a trade.
This chart pattern is actually a powerful arsenal in trading when you’ve mastered how to find it and implement it in an actual trade. To effectively master this pattern all you have to do is perform diligent research in finding the markets that are equipped with this pattern. Also, constant practice in implementing this pattern would provide you with confidence and certainty when making decisions. eToro comes with a virtual portfolio where you can apply your new-found knowledge about the head and shoulders as well as the reverse head and shoulders pattern.
Thank you and Good luck!
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