To keep in the theme of the recent lessons, the head and shoulders pattern is another trend reversal pattern that we can use to identify when the market may be about to turn.
This pattern is also similar to the double top/triple top patterns and we trade it in pretty much the same way, with only a few variations. First of all, here is an example of a head and shoulders pattern.
As you can see from the image above, it is very similar to the triple top, however the peaks are of different heights and the neckline is not strictly horizontal.
A head and shoulders pattern is formed first by a peak (the shoulder) followed by a higher peak (the head) followed by another lower peak (the second shoulder).
In this instance, we draw the neckline by connecting the two lowest points that are visible from the pullbacks. More often than not the line will not be straight, but don’t worry this is typical for a head and shoulders pattern.
So how do we trade this? Well, we use the exact same method as the triple top and double top. Simply wait for a clean break of the neckline and then enter our SELL positions. We can expect a pullback to be a similar distance to the difference between the head and the neckline.
Tip: Some traders say that the signal is more accurate when then neckline is a downslope. This would signify that the market is clearly losing strength and the possibility of a clean break of the neckline is more likely.
Inverted head and shoulders
As with most of these patterns, there is always a mirror pattern that works in the exact same way. Here is an example of an inverted head and shoulders pattern.
As you would expect, the inverted head and shoulders pattern only arises in a downtrend and must meet all of the same criteria as the standard head and shoulders pattern.
We simply place a LONG once there is a clear break of the neckline and the trend reversal is confirmed.