Occurring during uptrends, the Head and Shoulder pattern is a reversal pattern which is considered to be very reliable. However, it is not a very common formation but once identified it can provide benefit to those trading with it.
Head and Shoulders is a bearish reversal pattern with a bullish equivalent called the Inverted Head and Shoulders pattern – as it occurs during downtrends and the head actually represents the lowest point of the formation. All basic rules that apply to standard version also apply to the inverted one, so we will only look at one version, the standard Head and Shoulders pattern.
A closer look at the Head and Shoulders pattern
The Head and Shoulders pattern is characterized by three peaks, where the middle peak is the highest, or the head. The left peak represents the left shoulder and the right peak is the right shoulder.
Another important element of this structure is the neckline, it is the most critical point of Head and Shoulders pattern. The neckline is defined as a line which connects the first and second troughs, located between the head and shoulders on either side. It serves as an activation point, which means that a break of the neckline activates the Head and Shoulders Pattern. Until the neckline is broken, we consider the pattern to still be in development and we don’t initiate trades based on it just yet.
The right shoulder in particular bears an important psychological message. Up to that point, all previous peaks were characterized as higher highs i.e. the price action was in a clear uptrend. The third peak is the first time that the bulls were unable to push the price action to a new high, which essentially initiates a correction.
Validating and activating the Head and Shoulders pattern
The basic rule of the Head and Shoulders pattern is that it should occur only during a clear uptrend. One of the basic trading mistakes related to this formation is that crypto traders identify three peaks that resemble the Head and Shoulder pattern that occurs as the asset trades sideways.
Once the trend is identified, the structure should clearly resemble a three-peak formation. Once we have clearly defined two shoulders and a head, we move to connecting the lowest points of the two troughs and forming a neckline. You shouldn’t be confused if the neckline is slightly bent to one or the other side as it is almost impossible to draw the neckline in a perfectly straight horizontal line.
Finally, the pattern is only confirmed once the neckline is broken. For this to happen, traders are advised to wait for a clear close on a daily time frame below the neckline in the standard Head and Shoulders pattern, or above the neckline in the Inverted Head and Shoulders formation. As explained above, the neckline acts as the trigger line for the activation of the pattern. Up to that point, Head and Shoulders pattern was only in development mode.
Trading the Head and Shoulders pattern in the crypto charts
In the price chart below, we see how you should trade the Head and Shoulders pattern. As the price action moved in the uptrend, it forms three peaks with the right shoulder as the first lower high. The price action starts correcting lower as it approaches the neckline, therefore activating the overall pattern.
Once we have a clear breakout below the neckline, we consider opening a trade. There are two different entry points generated by this trading indicator:
1) We initiate the trade as soon as the price closes below/above the neckline or;
2) We wait for the price to break the neckline and then return for a re-test.
Many crypto traders prefer using the second approach as it is more reliable. The first option may result in a failed breakout if the price action returns below the neckline. This is why more experienced traders wait for a retest to act as a double confirmation. In this case, the retest happens quite late. Either way, a stop-loss order should be triggered if the price action returns above the neckline – which would invalidate the entire pattern as no follow through has been ensured.
The take profit order is calculated by measuring the distance between the top of the head and the neckline. This line should be copied and applied below so that it starts from the break point of the neckline and extends to the downside.
The point where the copied trend line ends is the profit-taking level.