If you have been day or swing trading for some time, you have probably heard others mention the head and shoulders candlestick pattern. Many traders can attest to how they often look for this pattern as one of their confirmations before entering a trade.
It does not matter the type of market (trading stocks, trading forex, or futures), this pattern can be found on any given price chart. This article will discuss the head and shoulders pattern and how to use it within your trading strategy to determine stock price movement.
Higher Highs & Lower Lows Defined
Before we first discuss how to identify the head and shoulders candlestick pattern on a price chart, let’s start with an understanding of trending markets and the concept of higher highs and higher lows.
In an up trending market, a given stock price rises upward, which means the stock is making higher highs. For example, a few days ago, the stock price for XYZ was $75. However, today, the stock price rose to $80. In this case, we would say that the stock is making higher highs. See the example below of a higher high illustrated on a chart.
In a down trending market, a stock price declines and makes lower lows. So, XYZ stock could have moved from $75 to $70 today. See the example below of stock making lower lows.
Of course, to be in either an up trending or down trending market does require more than a few candlesticks to form to determine which direction the market will follow.
Head and Shoulders Defined
The head and shoulders candlestick pattern is a chart pattern that can indicate that a trend reversal may be imminent and the overall trend may be changing. In an upward trend, you can see the pattern when a stock makes higher highs, followed by candles that cannot go higher.
These candles receive resistance at one of the most recent high price points. A head and shoulders pattern indicates that the market may decide to move downward when in an uptrend.
The inverse head and shoulders pattern in a downtrend is seen when a stock makes lower lows, followed by candles that cannot go lower. Those candles begin to find support at one of the recent lower levels.
So, an inverse head and shoulders pattern can indicate that the market may decide to move upward when in a downtrend.
The head and shoulders pattern gets its name because, in an uptrend, the middle peak of the chart pattern looks like an individual’s head, and the two lower highs next to the top can appear to be the shoulders of a body.
The left shoulder and right shoulder have a similar height, but they do not have to be the same candlestick values.
In a downtrend market, a head and shoulders pattern looks more like a person upside down or an inverse pattern.
Don’t worry if you don’t understand yet. We have some examples to help you visualize them.
Head and Shoulder – 3 Candles
Head and Shoulder – Series of Candlestick Pattern
Inverse Head and Shoulder – 3 Candles
Inverse Head and Shoulder – Series of Candlestick Pattern
Head and Shoulders Formation
A head and shoulders pattern can form from 3 or more candlesticks or a series or grouping of candlesticks. Sometimes, they can indicate a sign that a reversal may be upcoming. Head and shoulder patterns formed from a series of candles may be more reliable than ones from just a few candles, as these may only be minor pullbacks or corrections.
Another item to note is that these candlestick patterns can form on any chart, whether on a 1-minute or daily chart. They can appear everywhere. Once you start to look for them, they will immediately begin jumping out on every chart you review.
Benefits of the Head & Shoulders Candlestick Pattern
1. Not a Lagging Indicator
Unlike indicators like the MACD or RSI, the head and shoulders pattern does not lag behind the price. It is solely based on the current price and what is happening at the moment.
2. Takes Into Account Price Action
This pattern is based on how candlesticks form within a given market context. It is not determined by a complex numerical calculation that many would not understand. It allows you to more easily focus on price action as you can see the current price movement and fear and greed in the candles as they form.
3. Can Be Easily Identified on a Chart
Once you start identifying head and shoulders patterns, it will become almost second nature to spot them going forward.
4. Simple Trading Approach
Using head and shoulders as a trading entry criteria can offer a simplistic approach to trading, especially if you are one of the traders using multiple indicators on your chart to determine when you will enter and exit trades.
Trading Head and Shoulders
Let’s discuss how they can be used for trading once recognized on your trading chart. Once you identify the head and shoulders pattern, you will need to find the neck. In an upward trend, the neck would represent the lowest price point the stock got to as the pattern was forming. See the example below.
Some traders would look to enter a short position as the most common entry point when the stock price closed below the neck of the head and shoulders pattern.
Traders would enter a long position for an inverse head and shoulders pattern when the price closed above the neck.
See example below of the neck of the pattern.
As far as risk management is concerned, stop losses can be set as the middle peak of the head of the pattern. It depends on the price range from the head to the neck if that approach would be feasible.
For those inverse head and shoulders patterns, stop losses can be set below the valley of the head.
In terms of profit target areas, the next support and resistance levels may be a good place for possible profit targets for your exit.
Please note that you do not have to rely solely on the candlestick pattern to serve as confirmation to enter a trade. You can also include additional confluences or confirmations in your trading strategy to increase your confidence in your plan.
Summary of Head and Shoulders Candlestick Pattern
To some, the head and shoulders pattern can be one of the most reliable patterns used in technical analysis for day and swing trading. It can also serve as an additional confluence on the market’s direction. Although it can be a reliable trading confirmation, it is not one of the patterns traders in our program look for to trade. Our traders rely on a four candlestick set up to serve as confirmation for our trade entries.
Maurice Kenny has helped over 600 people become financially free through one-on-one coaching, mentorship, and options trading strategy. Many of these new traders are now full-time traders, and they all started by watching his 1-hr webinar.
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