The head and shoulders strategy revolves around the head and shoulders TA pattern. If you are unaware of this pattern then we recommend that you read our article on the H&S pattern before proceeding.
Learn more about the Head & Shoulder pattern.
When looking at the H&S pattern, it is a bearish formation. However, there are also inverse H&S patterns in TA, with these patterns representing a bullish reversal.
Three key H&S strategy pointers
1 – use the correct time frame
When trading the H&S the pattern with cryptocurrencies, it is typically most reliable when using time frames between the 1 hour – 1 day candles. When using lower time frames the unreliability is compounded by the increased messiness of the formation itself, thus making it tricky to identify the neckline. For example in the chart below we can see an inverse H&S formation on the 15 mins time frame. The formation is messy, the neckline is tricky to identify and therefore the likelihood of trade failure is increased.
BTC/USD H&S low timeframe
2 – wait for breakout confirmation & retrace
When trading the H&S pattern it is important that you wait for confirmation of breakout. If a trade is placed on the breakout candle itself, the likelihood of failure is increased. Additionally, if you try to predict that there will be a breakout in a certain direction, rather than reacting to the breakout itself, the likelihood of failure is increased.
When a H&S formation occurs and the neckline is broken below, it is very common to see a pullback towards the neckline.
Rather than placing the trade immediately on the breakout (which also has high risk due to it being a potential fake out), traders typically look to place the trade on the pullback. Below we can see an example of this. The main benefits from placing the trade on the retrace is that the risk levels are decreased while overall risk-reward ratios increase.
ETH/BTC wait for the retrace
3 – ensure you use a stop loss
Using a stop loss when placing a H&S trade is crucial. When trading with the H&S the stop loss should be placed at the 0.5 Fibonacci level using the points from the right shoulder. Below we can see an example of this.
When looking at the chart below we can see a clear H&S formation. The initial target for profit taking would have been the left shoulder origin, around a +3% gain if a short position had been taken.
We can see from the substantial green candle on the right. If a stop loss had not been placed at the 0.5 level at the pink line, major losses would have followed as BTC proceeded to increase 9.67% in one hour.
Which coins are H&S formations most effective with?
Due to the high amount of influence which BTC has on alt coins, alongside higher volatility (which makes H&S less accurate on the low timescale BTC charts), altcoin/USD charts are highly ineffective when looking at H&S formations. On the altcoin/BTC charts H&S formations are relatively rare in comparison to BTC/USD charts. Although when discovered they are generally quite effective. Below we can see an H&S formation with the ETH/BTC pair.
On the whole H&S formations are most effective when used with the BTC/USD chart with a lower likelihood of failure than with alt/USD charts.
The H&S formation is typically effective at showing future price movements. However, if traded incorrectly without using a stop loss, not waiting for a retrace, using alt/USD charts and using incorrect time frames then the trader is likely to do more harm than good to their portfolio.