Head and Shoulders Pattern: How to Trade It in XM
Today I’m going to show you step-by-step how to trade the head and shoulders pattern.
In fact, I even traded several of the examples you’re about to see.
And I should point something out:
This is not a guide for the advanced traders only. I’m a big believer in keeping things simple.
So whether you’re just starting out or a seasoned pro, you’re going to love this guide.
Let’s get started.
Before you can trade it, you must first know the key attributes of the pattern. That way you can easily spot the most favorable head and shoulders to trade.
Attributes of the Head and Shoulders Pattern
Let’s start with the illustration below.
As you can see from the drawing above, the head and shoulders pattern has five attributes.
In order of occurrence, they are:
- Left shoulder
- Right shoulder
However, we need both shoulders and the head of the pattern before we can identify the neckline. If that sounds confusing, don’t worry. It will make more sense as you progress through the lesson.
Now let’s discuss each step in greater detail.
Step 1: UptrendThe very first part of a head and shoulders pattern is the uptrend. This is the extended move higher that eventually leads to exhaustion.
As a general rule, the longer the uptrend lasts, the more substantial the reversal is likely to be.
The market moves down to form a higher low. At this point, things are starting to come together, but we don’t quite have enough to draw the neckline.
Step 2: Left shoulder
Now that the left shoulder has formed, the market makes a higher high which forms the head. But despite the bullish rally, buyers are unable to make a substantially higher low.
Step 3: Head
At this point, we have the left shoulder and the head of the structure. The neckline is also beginning to take shape, but we need the right shoulder before we can draw the neckline on our chart.
The right shoulder is where things come together. It’s an indication that buyers are tiring and that the market may be gearing up for a reversal.
Step 4: Right shoulder
As soon as the right shoulder begins, we have enough to start plotting the neckline. But because the pattern isn’t yet complete, it’s best to think of it as a rough draft rather than a final version.
Now that we have a defined head and two shoulders we can draw neckline support. This level will become a key component when we get into how to trade the breakout.
Step 5: Neckline
Think of the neckline as the line in the sand between buyers and sellers.
What Causes a Head and Shoulders to Form?All price action carries with it a message. Some messages are easier to read than others, but they’re always present.
Concerning the head and shoulders pattern, the message is that buyers are tiring and that you’d best prepare for a potential reversal.
But what is it about the pattern that causes the market to reverse? How can a few simple swing highs accomplish this?
These are the kind of questions that will help you unlock the clues and take you to the next level.
But there’s a problem…
The way I phrased the two questions above fails to capture the essence of the head and shoulders pattern.
You see, it isn’t the price structure itself that causes the market to reverse. It’s the transition that occurs between buyers and sellers. The pattern is just the outcome or byproduct of that process.
To better explain things let’s look at it from a different perspective. For this, we’re going to use a real head and shoulders formation that occurred on the GBPJPY weekly chart.
Notice how after carving out a higher high (head) and pulling back, buyers were unable to push the price back above the head. This eventually formed the right shoulder.
The lower high would be a big red flag if you were a GBPJPY bull during this time.
Let’s take another look at the same GBPJPY chart.
If you’ll remember from the lesson on how to determine trend strength, the telltale sign of an impending trend change is a shift in the sequence of highs and lows.
For example, a market that’s been carving out higher highs and higher lows may be in trouble with a single lower high.
However, a trend is not technically broken until we get a lower high and a lower low. Note how the price action inside the second red circle above took out the last swing low.
As soon as that low was taken out, the GBPJPY signaled that buyers were in trouble.
The head and shoulders reversal doesn’t work because of the pattern itself. It works because of the way in which the highs and lows develop and interact with each other at the top of an uptrend.
Always remember to keep it simple. All we’re doing here is identifying a potential shift in trend by focusing on the relationship between highs and lows.
One important thing to keep in mind about the head and shoulders pattern is that it’s only confirmed on a break of neckline support.
Head and Shoulders Breakout
And by break, I mean a close below it.
A common mistake among Forex traders is to assume the pattern is complete once the right shoulder forms.
In fact, it’s only complete and thus tradeable once the market closes below the neckline.
Notice in the illustration above that the market has closed below the neckline. This confirms the head and shoulders pattern and also signals a breakout.
Now let’s go back to our GBPJPY head and shoulders pattern example to see where it was confirmed.
Notice how it took a daily close below neckline support to constitute a confirmed break. While there were a few previous sessions that came close to breaking the level, they never actually closed below support.
Next, we’ll discuss a few entry methods for trading the head and shoulders.
How to Enter a Break of Neckline SupportSo far in this lesson, we have covered the five attributes of a head and shoulders pattern. We have also discussed how to differentiate a formation that’s still intact versus one that has broken down.
Now for the really fun part – how to trade and of course profit from a head and shoulders reversal.
There are two schools of thought on how to enter a breakout. The first is to use a pending order to go short just below the neckline. Note that those who use this method are not waiting for the market to close below the neckline.
The problem with this approach is that you leave yourself exposed to the possibility of a false break. You’ll often see a pair dip below support on an intraday basis only to close back above the level before 5 pm EST.
Which brings us to the second approach, and the one I prefer. This method involves waiting for a daily close below the neckline before considering an entry.
By doing this, you mitigate the risk of having the market snap back on your position and stop you out for a loss.
Because of this, we’re only going to focus on the second approach. But even when waiting for the market to close below the neckline there are two entry methods to consider.
Let’s discuss each in detail.
The first way to enter a head and shoulders break is to sell as soon as the candle closes below support.
Entry Method #1
For example, because we’re analyzing the GBPJPY on the daily time frame, we’d wait for a daily close below the neckline. That would be our signal to go short (sell).
Here’s how that would look:
Notice how we’re entering short as soon as the pair closes below neckline support.
While the method above has its uses, I usually prefer to wait for a retest of the neckline as new resistance.
Entry Method #2
This brings us to the second entry method.
Notice how with the second entry method we’re waiting for a retest of the neckline as new resistance.
This accomplishes two things:
- It helps validate the recent break
- It offers a more favorable risk to reward ratio
Despite being straightforward, the stop loss placement when trading the head and shoulders is a controversial topic. Some traders prefer a stop above the right shoulder whereas others choose a more aggressive placement.
Stop Loss Placement and Risk Control
Like everything you do in the Forex market, it comes down to what works best for you.
With that said, I tend to believe that a stop loss above the right shoulder is excessive. It unnecessarily and adversely affects your risk to reward ratio.
A head and shoulders is confirmed with a close below the neckline, right? So a close back above that same level would negate the pattern.
Now, assuming my stop is above the right shoulder, am I going to wait for the market to take me out if it closes back above the neckline?
Of course not.
So really there are three ways to exit the trade should things turn sour. Let’s start with the first and, in my opinion, less appealing way and then we’ll finish up with my two favorites.
The first area you can place your stop loss is above the right shoulder.
Stop Loss Placement #1
Notice how this option provides an ample amount of space between your entry and stop loss.
However, this isn’t necessarily a good thing. I’d even argue that it does more harm than good. You see, a stop loss that high means you’ve also cut your potential profit in half or worse.
In the case of the GBPJPY pattern the measured objective, which we’ll get to next, is 1,800 pips below the breakout point. If you chose this first option to set your risk, it means you’d have a 500 pip stop. If we divide that into the objective, we get 3.6R.
That’s pretty good but let’s see what we could have had using the section option.
This is my preferred stop loss placement. It allows for a much better risk to reward ratio while still affording me the ability to “hide” my stop.
Stop Loss Placement #2
Here’s how it looks on the GBPJPY chart:
Note that I’m placing the stop above the last swing high. This is still about 200 pips from my entry, so it’s hidden, but it isn’t so far away that it adversely impacts my potential reward.
You can always go tighter if you’d like as it all depends on what fits your trading style. Just remember that the closer your stop loss is to your entry the greater the chance of being taken out of the trade prematurely.
Remember the 3.6R profit with the first stop loss placement above?
By setting your stop above the last swing high instead, you’ve cut your stop loss distance from 500 pips down to 200 pips. With an 1,800 pip objective, that’s an incredibly profitable 9R.
To put it in hypothetical terms, that’s a 7.2% profit versus an 18% profit, assuming you risked 2% of your account balance on the trade.
Exit on Close (Safety Net)
I call this my safety net. Because any daily close back above the neckline suggests invalidation. And I don’t know about you, but I’d rather take a 50 pip loss than a 100 pip loss.
Referring to the GBPJPY example above, if the market had closed back above the neckline after it closed below it, we would want to exit the trade. Such a close would signal that the pattern is no longer valid and that sellers are no longer in control.
In fact, this notion can be applied to just about any pattern you trade. It can help reduce the size of a loss in the event the market turns against you.
Head and Shoulders TargetKnowing when to take profit can mean the difference between a winning trade and a losing one. It’s arguably the most challenging aspect of trading.
When it comes to the head and shoulders pattern, there are two ways to approach it. And for some, a blend of the two may be the way to go.
The first and more conservative approach is to book profit at the first key support level. These are the areas you’ve defined that could cause the market to bounce. As such, it may be a good idea to take profit on a retest of one of these areas.
Because every situation is different, these support levels will vary. But the one thing that must always be true is a favorable risk to reward ratio. So always be sure to do the math before taking the trade.
The second and more aggressive approach is to use a measured objective.
Although using a measured objective is more aggressive as your target is further away from your entry, it’s also more universal.
Why is that, you ask?
When you use this method, you’re taking a measurement of the height of the entire pattern. So regardless of the situation, you will always have a specific target area.
Here’s one taken from the EURCAD daily chart:
Note that I measure from the top of the head directly below to the neckline. I then take that same distance and measure lower from the breakout point.
Measuring from this point is a small but significant detail, especially for necklines that develop at an angle.
One last note about measured objectives. Although they can be extremely accurate, they are rarely perfect. So as an added layer of defense, it’s best to think of them as general areas rather than specific levels.
Also, try to find a key support level that intersects with or at least comes close to the measured objective. This will help you validate the target area and give you a greater degree of confidence during the trade.
Who doesn’t like more examples? I know I do.
A Few Examples
So to start wrapping things up, here are a couple more examples of the head and shoulders in action.
Be sure to take note how each structure forms in its own unique way yet is still highly effective at signaling a reversal.
First up is the EURCAD daily chart.
Notice how in this case the measured objective lined up with a key pivot area. While it’s not required, this can add a greater degree of confidence to any trade idea resulting from the reversal.
The second reversal pattern formed on the USDJPY weekly time frame after a multi-year uptrend.
A significant difference here from the first EURCAD reversal is that the USDJPY neckline is a horizontal level. This is perfectly acceptable but isn’t very common.
In most cases, the neckline support will form at a diagonal. The pitch of the level can vary, but one thing must always be true – the level should move from lower left to upper right. Note the angle on the first EURCAD chart above.
So by this point, you’re familiar with the attributes of the pattern, where to find it and most importantly, how to enter and exit for profit.
Key Insights Before You Go...
But there are a few key insights I want to share with you before you go. Think of these as rules to follow when trading the head and shoulders pattern.
Let’s get started.
The pattern must form after an extended move higher
This rule is self-explanatory. It can only be a bearish reversal pattern if it forms after an extended move higher.
One way to double check is to make sure there are no immediate swing highs to the left of the formation.
Take a look at the charts above. Notice all the white space to the left. That’s what you want to see when trading any bearish reversal pattern.
Neither shoulder can be above the head
You can’t raise your shoulders above your head, right?
For your sake, I hope not.
The same applies to this technical pattern. The head should always stick out above both the left and right shoulders. And while there’s no exact rule for the distance, it should be evident from a quick glance.
The neckline should be horizontal or ascending but never descending
If you find a head and shoulders where the neckline moves from the top left to the bottom right, you may want to stay on the sidelines.
For example, if you see this:
It’s a sign of a “weak” reversal pattern. And while you may still enjoy a favorable outcome, the odds aren’t in your favor.
Instead, this is what you want to see:
Note how the neckline is moving from lower left to upper right. This suggests a “healthy” head and shoulders pattern and one you probably want to keep an eye on.
In my experience, the steeper the angle of the neckline, the more aggressive the breakout and reversal is likely to be. Look no further than the GBPJPY example above.
The shoulders should be on the same horizontal plane
This one is a bit tricky to explain, so an illustration seems more appropriate.
Notice how both the left and right shoulder “overlap” to some degree. Each shares a portion of the same horizontal plane. They don’t need to overlap entirely, but they do need to share a portion of the highlighted area above.
If you find a price structure that doesn’t fit this description, it isn’t technically a head and shoulders.
Stick to the daily and weekly time frames
Last but certainly not least are the time frames that tend to perform the best. After several years of trading these reversals, I can say with certainty that they are most reliable on the daily and weekly time frames.
While you can trade them on say a 1-hour or 4-hour chart, you run the risk of finding a lot of false positives. That is a pattern that looks like a head and shoulders but doesn’t perform like one.
To avoid this be sure to stick to the daily time frame and higher. After all, that’s where you can usually find the most consistent trends.
There are many different ways to trade reversals in the Forex market, but few are as consistently profitable as the head and shoulders.
It isn’t just about trading a technical formation. It’s about “reading” the price action to understand the fundamental shift between buyers and sellers.
While there are no guarantees in the Forex market, the head and shoulders strategy you just learned is as close as it gets. Follow the guidelines above, and you’ll be well on your way to achieving consistent profits.
What is a head and shoulders pattern?
What makes the head and shoulders so effective?
What does the neckline represent?
Where should a head and shoulders pattern develop?