The Head and Shoulders Formation
What are Chart Formations
Chart formations are technical analysis patterns formed on a chart, which allow a trader to interpret the market conditions and anticipate future price movements. Chart formations are a similar concept to chart patterns, but they differ in the sense that they interpret a larger set of data and are more loosely defined. This means that chart formations are a lot more dependent on the trader’s interpretation of the chart, rather than on a strict set of rules. Some popular chart formations even carry names that refer to their resemblance to a real life object, like the head and shoulders pattern and the rising cup. This means that it is impossible to define an exact mathematical formulation and many times the formation is dependent on the trader’s imagination.
In this article, we will introduce you to two popular chart formations, the head and shoulders formation and the inverted head and shoulders. Below we explain what these formations are, how to identify them, and eventually how to trade them.
What is the Head and Shoulders Formation
A head and shoulders chart pattern is a chart formation that is composed of three peaks, with the one in the middle being the highest one, resembling the head, and the other two being slightly lower, resembling the shoulders. The interpretation of a head and shoulders formation is the following. The two first peaks of the formation indicate a typical zig zag pattern found on any bullish trend on the chart, with higher highs and higher lows. The third peak that is formed below the head peak, indicates that bears seem to gain momentum, and that a price reversal to lower prices is possible, since the price seems to have reached a strong resistance point. Below we can see a typical head and shoulders trading pattern from Fondex cTrader.
The Inverse Head and Shoulders Formation
The inverse head and shoulders pattern is a formation that is the exact opposite of head and shoulders one. This means that the three relevant peaks are price lows, with the middle one being lower than the other two. Again, the formation below is taken from Fondex cTrader.
An inverse head and shoulders mean that a strong support zone has been reached, so maybe it is the time for the price to continue moving upwards.
How to Trade Head and Shoulders and Inverse Head and Shoulders Formations
As explained above, the two chart formations are used to identify trend exhaustion and a possible trend reversal. In this section, we will briefly describe a strategy that can be used in conjunction with head and shoulders and inverse head and shoulders formations. Our strategy is pretty straightforward and it goes as follows:
For head and shoulders:
Identify the second shoulder.
After two consecutive bearish bars confirming the reversal, enter a sell position.
Assuming that the head high identifies a resistance area, set your stop loss a bit higher than the head high..
Set your take profit with a 2:1 ratio.
In the image below you can see what the setup would look like for the head and shoulders pattern we demonstrated above.
For inverse head and shoulders our strategy would be inverted and modified as follows:
Identify the second shoulder.
After two consecutive bullish bars confirming the reversal, enter a buy position.
Assuming that the head high identifies a support area, set your stop loss a bit lower than the head high.
Set your take profit with a 2:1 ratio
In the image below you can see what the setup would look like for the inverse head and shoulders pattern we demonstrated above.
As we can see from the above setups, both trades would have resulted in a profitable outcome. Concluding the head and shoulders and the inverse head and shoulders chart formation can be useful tools in analyzing the current market status and identifying potentially profitable entry points. Nevertheless, as with any technical analysis tool, the prediction accuracy can be substantially increased if used in conjunction with another technical analysis tool e.g. a higher timeframe trend indicator.
Limitations of the Head and Shoulders Formations
Head and Shoulders formations can generate a lot of false signals that could lead to substantial losses if used out of context. Therefore, when using strategies based on chart formations, always consider the market fundamentals that currently move the market and combine the signals with other confirmation signals, like oscillators, support/resistance levels and the relevant price action taking place on the chart.
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