What is a head and shoulders pattern and how to profitably trade it

Do you want to know more about candlestick patterns and how to trade a head and shoulders pattern? Watch our latest video to find out what is a head and shoulders pattern and how to take advantage of it.

What is a Head and Shoulders Patterns- A simple explanation

One of the most powerful reversal patterns that traders tend to use is the head and shoulders pattern. This is a pattern of several candlesticks that makes an initial surge higher, pulls back, and then breaks even higher than that. However, by the time the buyers make their third attempt to push the market to the upside, they run out of steam. This essentially makes three humps on the chart, and the fact that we feel the make a “higher high” suggests that we are running out of momentum.

The head and shoulders pattern also has a neckline which is the bottom of the pattern. Once we break below it, the sell signal is triggered. The truly powerful thing about the head and shoulders pattern is that it comes with a built-in measuring stick. You measure from the top of the “head”, which is the middle home, to the neckline. You take that distance and subtract it from the neckline once we break down below it, and that’s your longer-term target.

It should be noted that there is such thing as an inverse head and shoulders pattern as well. It is the exact opposite. In other words, it is the market trying to sell off, but failing to make a “lower low” on the third push lower. With this, it shows that an impending reversal could be coming. You trade this the exact same way you do the standard head and shoulders, but you are obviously buying at that point in time.

Looking at the EUR/AUD daily chart, you can see that we formed a head and shoulders with a neckline at the 1.50 level, and the top of the pattern at the 1.58 level. Once we ended up breaking down below the neckline finally, this signaled that traders would more than likely be targeting and 800 pip move. By subtracting that from the 1.50 handle, it gives us a target of 1.42. You can see that we finally did in fact target that level and not only reach it, but actually went lower over the longer term. The self-fulfilling prophecy of the pattern worked out, as most of the trading community would have certainly noticed this large head and shoulders.