What Is Head And Shoulders Pattern And How To Use It In Trading?
Charts perfectly help traders to notice the right moment to open and close positions. Today we will tell you about one of such financial tools, the Heads and Shoulders pattern. From this article you will learn about how to identify it on the chart, what sets its inverted version apart, and how to trade for maximum profit.
What Is A Head And Shoulders Pattern?
Let's start with the definition. Head and Shoulders is one of the most reliable technical analysis patterns in crypto that traders use to predict trend reversals. It helps to determine when prices will stop falling and start rising (or vice versa).
Visually, this pattern consists of three peaks of different sizes. The highest part is the middle, which serves as the head and indicates a bullish sentiment. In this part, the price grows and reaches its maximum. The peaks on the two sides serve as shoulders; most often, they are about the same length. The larger the pattern is, the steeper the price drop after the reversal.
An important element of the pattern is the neckline, which represents the support level. It connects the lows after the left shoulder and the head. A broken neckline turns from support to resistance, signaling the completion of the graph and the start of a bearish trend.
How To Identify Head And Shoulders Pattern?
It is not always easy to find a pattern on a dynamic chart, especially when you are new to crypto trading. For such cases, we have prepared a detailed guide on how to identify “Head and Shoulders”:
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Find the uptrend: make sure that the price was in a clear uptrend movement. This is important because the pattern signals a possible downward trend reversal.
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Look for the three peaks: the second wave is the highest, and the sides are slightly smaller. They should be clearly visible, and the pullbacks between them should be clear enough. Ensure that there is no further upward momentum and the quotes cross the support level, heading downward. This indicates a bearish reversal, which is what the pattern warns about.
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Identify the neckline: draw a line through the minimum points of the left shoulder and the head. It is normal for the neckline to be slightly sloping, but too much bending can indicate a low reliability of the pattern.
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Wait for the breakout: this is the key factor that confirms the pattern. The breakout of the neckline is usually accompanied by a sharp increase in trading volume. Use additional indicators, such as RSI or MACD, to confirm the weakness of the uptrend and the strengthening of bearish sentiment.
This process may seem complicated at first, but over time you will develop more skill. The good thing is that by following this algorithm, you will be able to identify the pattern most confidently and incorporate it into your strategy.
Inverted Head And Shoulders Pattern
It is important to note that “Head and Shoulders” is a reversal figure, and it has a mirror version. Inverted “Head and Shoulders” is a bullish pattern that signals a possible reversal of a downtrend into an uptrend.
Structurally, this pattern also consists of three main parts; they are located downwards, and instead of peaks, there are troughs. The second part is the lowest point, which serves as the head. This means the lowest value of the asset. The shoulders are located on the sides, approximately at the same level relative to each other. The troughs demonstrate the decreasing potential of bearish dynamics.
This pattern also has a neckline, which represents the resistance level connecting the minimums of the bounces after the left shoulder and the head. Breaking this line upwards indicates the completion of the pattern and the start of an uptrend.
How To Use Head And Shoulders In Trading?
Now let's go even deeper into the practical application of this strategy, specifically in crypto trading. Follow this algorithm and pay close attention to the details to avoid mistakes, which could cost your profits:
- Identify the pattern on the chart: look for three key elements where the highest peak is the head of the pattern. Make sure the graph forms after an uptrend. Find the neckline and expect it to break down.
If the pattern forms after a price drop, it will be “Inverse Head and Shoulders”. It signals a possible reversal of a downtrend into an uptrend.
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Wait for the neckline breakdown: keep in mind that the pattern completes after the neckline breakdown downwards. For the mirror version, the price should close above the neckline.
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Open a trade: enter a short position right after the breakout candle closes below the neckline.
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Determine the target level and set a stop loss: measure the distance from the top of the head to the support and set it down from the breakout point. This will be the approximate target level. Set your stop loss above your right shoulder to minimize risk. Congratulations, you are closer to profit!
To make it clear, let's consider a concrete example. Suppose you see the Head and Shoulders pattern on the asset chart. First you spot the left shoulder, where the asset went up to $40. Then, you identify the head, where the price reached $45. Next comes the right shoulder, and the price drops to $42, then rises again to $43. The neckline is at about $42, where the breakout will occur. The potential profit will be $3.
Pros And Cons Of The Head And Shoulders Pattern
Each financial instrument has advantages and disadvantages, we have prepared a table so that you can see the properties of the Head and Shoulders pattern clearly:
Aspects | Characteristics | |
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Pros | Characteristics Application on any timeframes. The pattern works on all time intervals, including day and night. Versatility of charts. “Head and Shoulders” can be used on both line and candlestick charts. Accuracy in determining entry and exit points. The pattern provides clear levels for entry (breakout of the neckline) and exit (target level). Compatibility with other tools. Traders use it with other indicators (RSI, MACD) and support/resistance levels to improve signal accuracy. | |
Cons | Characteristics Slow formation. The pattern can take time to shape, especially on higher time frames, which requires patience. Difficulty in early-stage identification. It is hard to recognize the pattern at its early stages as it requires half of the finished chart. Unclear to read. The pattern looks indistinct on the charts due to irregular price movements, making its identification harder. Hard for newbies. Inexperienced traders may miss the pattern or misinterpret it. |
We can conclude that “Head and Shoulders” is a reliable and versatile pattern. It shows the sentiment of the market, gives a clear understanding of the breakdown, and establishes positions. You can always check the effectiveness of the strategy on the Cryptomus exchange. The wide variety of trading pairs give the opportunity to use this chart many times and make sure of its effectiveness.
Have you ever used the Head and Shoulders pattern? Write about your experience in the comments!
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