Head and Shoulders Pattern: How to Identify and Use?

When learning about forex trading, price patterns, and candlestick patterns are what traders prioritize. Which, Head and Shoulders Pattern – is the most important and popular model in technical analysis. The model is used to provide traders with an intuitive way. Helps them identify trend reversals and predict future price movements. In this article, let’s learn with Forex Trading about how to identify and use this type of model.

Learn about the head and shoulders pattern in Forex trading

The head and shoulders pattern is considered one of the reliable trend reversal patterns when traders participate in Forex trading. This type of pattern is used to signal, with a high degree of accuracy, that an uptrend is about to end.

What is a head and shoulders pattern in technical analysis?

Head and Shoulders Pattern is commonly used in technical analysis. This is a chart formation used to be able to predict a trend reversal from bullish to bearish or vice versa. This type of model is formed in the form of 3 peaks or 3 bottoms. In which the two outer peaks are approximately the same height and the middle peak/bottom is the highest.

The H&S pattern forms when prices rise to a peak and then fall back to the base of the previous price increase. After that, the price rises above the previous peak, forming “Head” and then falls back to the corresponding initial price. Finally, the price peaks again at a level equivalent to the first peak of the formation before falling again.

In addition, to predict price trends through reversals, we can apply Japanese candlestick pattern to increase trading efficiency.

The meaning and importance of this model in technical analysis

Meaning of H&S model:

• Signaling a trend reversal
• Trend confirmation
• Identify transaction entry/exit points

The importance of the H&S model:

• High reliability
• Easy to identify
• Wide application

See more: Master the Forex “game” with Price action

What are the characteristics you should keep in mind for the head and shoulders pattern?

• The two shoulders are relatively the same height
• The top is the highest position
• The neckline is horizontal
• Trading volume decreased
• Break through the neckline
• Confirmed by volume

Structural analysis of the head and shoulders price pattern

Left shoulder:

• Formed within the current price trend (up or down).
• Shows the strong up/down momentum of the trend.
• High trading volume.

Head:

• Higher than the left shoulder, showing the continuation of the trend.
• High risk of reversal.
• Trading volume can be high or low.

Right shoulder:

• Lower than the left shoulder, signaling a weakening of the trend.
• Completes the H&S pattern and creates a foundation for a reversal.
• Trading volume fluctuates at a low level.

Neckline:

• Is an important boundary line to confirm trend reversal.
• When the price penetrates the neckline, the trend reversal is confirmed.
• The direction of the breakout (up or down) indicates the new direction of the price.

Identify important factors of the head and shoulders price pattern

Three peaks:

• The left shoulder is the first peak that appears in the current trend.
• The head is the second highest peak and is higher than the left shoulder.
• The right shoulder is the lower high and completes the pattern.

Neckline:

• Connect the two lowest bottoms of the left and right shoulders.
• Is the boundary line to confirm trend reversal?

Trading volume:

• Usually increases when price forms the left shoulder and head, showing market interest.
• Decline when price forms the right shoulder, signaling a weakening of the current trend.

Ratio:

• The left shoulder should be approximately equal to the head or the head should be no more than 20% higher than the left shoulder.

Trading signals and strategies using the head and shoulders pattern

Trading signals and strategies for using the head and shoulders pattern in Trader Price Action are often based on confirmation of the pattern through breakouts and other factors. Below, Forex Trading will guide you on how to use this model effectively:

Trading signals in technical analysis with head and shoulders pattern

The key point here is that traders must wait for the pattern to form completely. This is because a sample may not develop at all, or a partially developed sample may not be complete in the future.

• In the H&S pattern, we wait for the price to move below the neckline after the peak of the right shoulder.

• For the inverse head and shoulders pattern, we wait for the price to move above the neckline after the right shoulder is formed.

Use resistance and support levels for technical analysis

Resistance level:

• The neckline is the horizontal line connecting the two peaks of the shoulders.
• After the price breaks through the neckline from above, the neckline becomes a new support level.
• Conversely, when the price breaks through the neckline from the bottom up, the neckline becomes a new resistance level.

Support level:

• After the H&S pattern completes and the price breaks through the neckline from above, the neckline becomes a new support level.
• This is the result of a reversal of the trend from bullish to bearish.
• The price could turn back and test this support level before continuing to lower.

In addition, support and resistance levels are also determined through the first part of the model:

• The top of the head is usually the highest point in the pattern. As the price advances and reaches the top of the head, it creates a strong resistance level. Prices often struggle to break above this level and it can be a key point for traders to place sell orders.
• The height from the top of the head to the neckline is often used to measure the model’s potential level. A potential support level can be identified by measuring this height and applying it to the breakout point through the neckline.

Confirm trading signals, place orders and manage risk with price models

• The most common entry point is when a breakout occurs – the neckline is broken and the trade is entered.

• This method refers to waiting for a retracement after the breakout has taken place. This is more conservative in that the trade could be missed if the price continues to move in the direction of the breakout.

Risk management:

Determine your stop loss at a level you can control:

• The stop loss is usually placed at the level of the break through the neckline and a certain safe distance.

Determine the profit you want to have:

• Determine a reasonable profit target based on the height of the head or other potential support levels.

See more: XTB: The most reputable and quality broker in UK

Use other technical indicators in combination with the Head and Shoulder pattern

MACD indicator:

• MACD can be used to identify changes in trend momentum.
• When MACD increases and crosses above the signal line. This confirms the buy signal when the price breaks through the neckline from the bottom up.

RSI line:

• RSI can help determine whether an asset is considered overbought or oversold.
• When the price advances and the RSI reaches overbought levels (above 70), this can provide a warning for a recovery or reversal in the price trend.

Moving average MA:

• 50-day and 200-day moving averages, to determine the direction of the pattern’s long-term trend
• When the price breaks through the neckline and simultaneously crosses above the moving average, this can provide additional confirmation for a buy signal.

Summary