Head And Shoulders Pattern Breakout : 3 Strong Ways To Trade Head and shoulders
Head and shoulders pattern breakout is a statistically reliable reversal phenomenon.
However, there are many misconceptions about how breakouts happen and how to trade them.
Traders frequently encounter issues such as failed breakouts, multiple stop loss hunting, and failure to identify the pattern itself.
Table of Contents
- What is the head and shoulders pattern?
- Head and shoulder pattern breakout example
- Types of Head and Shoulders Pattern Breakout
- 5 Tips to Trade Head and Shoulder Pattern
- Frequently Asked Questions
However, if you’re reading this blog, you’ll understand when and how to trade the breakout.
So, without further ado, let us define head and shoulder pattern breakout –
What is the head and shoulders pattern?
Head and shoulder pattern is formed with one swing high (head) being comparatively higher than adjacent swing highs ( shoulders).
When the market pauses after a long trend, we can see a head and shoulder pattern. It is important to note that this is just another way for the market to reverse direction.
The neckline is very important in confirming the head and shoulder pattern.
Neckline is drawn for Head and Shoulder pattern by connecting lower price levels of formation, which act as support level. The neckline for an inverse head and shoulder pattern is drawn by connecting higher price levels of the formation, which act as resistance levels.
A bearish reversal occurs when an uptrend is followed by a head and shoulders pattern; prices tend to decline, making lower highs, and a downtrend is subsequently declared to have occurred.
When a downtrend is confirmed by an inverse head and shoulder pattern, it results in a bullish reversal, which means that prices form higher highs and an uptrend is in place.
Head and shoulder pattern breakout example
Breakout from a head and shoulders pattern does not always result in a sharp downtrend.
Sometimes prices tend to retest the neckline, which then becomes a resistance level, as shown in the preceding example.
Also, keep in mind that the neckline should be regarded as a price level area rather than a simple line.
This is due to the fact that every instrument has- volatility.
Price levels do not always work as precisely as they should, so some price volatility should be allowed to lead the signals.
Types of Head and Shoulders Pattern Breakout
Now that you understand how patterns form, it is time to delve a little deeper into how you can spot trading opportunities using the head and shoulders pattern.
At this point, it is critical that you focus on price action rather than visualizations, as actual chart patterns may not appear as they do in textbooks.
There are three types of price action-based breakouts that are more reliable to trade with:
- Head and shoulder pattern breakout with retest
- Head and shoulder breakout without retest
- Head and shoulder pattern breakout with Flag or pennant
1. Head and Shoulders Pattern Breakout With Retest
After a successful breakout from the neckline, prices retest the neckline before eventually moving in the direction of the breakout.
- Entry :- Because we don’t know whether the price will retrace or not, we can enter on the neckline breakout itself; however, for risk management purposes, the initial quantity should be 50% of the trade’s planned quantity.
- Stop Loss:– 1 ATR above neckline resistance as a stop loss.
- Add To Position:– Once the retest is complete and you see that prices are falling after the retest, add the remaining 50% qty.
- Target:- The height of the head (the highest swing high) projected downwards; once the target is reached, the stop loss should be trailed to maximize profit from the trade.
2. Head and Shoulders Pattern Breakout Without Retest
Prices can sometimes break through the neckline and continue to fall due to strong selling pressure.
- Entry :- Enter the trade when breakout happens with a strong bearish candle ( check volume to reconfirm the momentum). Now as per risk management practice initial qty to be filled only 50%
- Stop Loss :- 1 ATR above neckline.
- Add To Position :- After 4-5 candles if there is no sign of retracement or if there is bearish momentum going on the rest 50% of the qty. can be added
- Target :- The height of the head (the highest swing high) projected downwards; once the target is reached, the stop loss should be trailed to maximize profit from the trade.
3. Head and Shoulders Pattern Breakout With Flag or Pennant
It is very common to see a flag or pennant just around the neckline before a breakout.
It is a very good signal to trade the head and shoulders pattern.
- Entry :- Once the flag breakout near the neckline has been confirmed, place the trade; we can trade in full quantity at this signal because the flag breakout serves as a secondary confirmation, and it is good risk management because the flag breakout makes it easier to manage the stop loss.
- Stop Loss :-Slightly above the upper boundary of the flag chart pattern formation.
- Target: Once the initial target of head height has been successfully reached, trail the stop loss.
5 Tips to Trade Head and Shoulder Pattern
- Avoid short-term uptrend developments with head and shoulder stock chart patterns, which are much more reliable for longer-term trend reversals.
- If the second shoulder forms below the first, or if the height of the second shoulder is lower than the height of the first, it generally indicates a good statistical reversal of the trend, because buyers are said to have lost momentum.
- Trading head and shoulders with RSI divergences has proven to be far more significant. Professional traders always look for such opportunities, and why should you not?
- Most importantly, don’t try to look for symmetry when analyzing shoulders; they may not always have a good height; instead, focus on price action and where the momentum is going.
- Finally, always trade head and shoulders with a trailing stop loss because a reversal can sometimes be the start of a very long term downtrend, which you should never miss as a trader –
Remember Trend is Your Friend and You Should Ride It Till End.
Frequently Asked Questions
What usually happens after head and shoulders pattern?
Following the breakout of the Head and Shoulder pattern, a bearish trend reversal occurs.
Why do false breakouts occur with the head and shoulders pattern?
False breakouts can occur with any pattern; the important thing is not to trade a pattern before it has fully manifested itself; doing so increases the likelihood of winning.
How reliable is a head and shoulders pattern?
Head and shoulder patterns are not very common because they usually appear after a very long bull run, but when they do appear, they are usually reliable.
Author is Senior Technical Analyst
At Bulls Arena Trading