Head and Shoulders: The Classic Trend Reversal Pattern

Comprehensive Analysis of the Head and Shoulders Pattern

1. Mechanics and Definition of the "Head and Shoulders" Pattern

1.1. Key Elements

The "Head and Shoulders" pattern is a classic reversal signal indicating the end of an uptrend. It consists of three peaks:

Left Shoulder

The first peak, followed by a retracement to the neck line. The volume on the left shoulder is typically low.

Head

The second, highest peak. Its formation is accompanied by increasing volume as buyers attempt to extend the trend.

Right Shoulder

The third peak, approximately at the same level as the left shoulder and with lower volume. The weakness of the right shoulder indicates waning demand.

1.2. Neck Line and Breakout

The neck line connects two local minima between the peaks. A downward breakout with increased volume (usually +20-30% above average) confirms the reversal.

1.3. Variations and Features

Sometimes, the neck line can be sloped—either downwards or upwards. The slope adds complexity but does not negate the signal. A retest is important: the price may return to the neck line and test it as a resistance.

2. Visual Identification and Key Levels

2.1. Constructing the Neck Line

For accuracy, it is better to construct the neck line based on candlestick closes. A horizontal neck line is the ideal option, but a slight slope is permissible.

2.2. Measuring the Target

The target is calculated as the difference between the head and the neck line, projected from the breakout point. For example, a shoulder at 100 ₽, head at 150 ₽, neck at 100 ₽ → target is 50 ₽ down from 100 ₽, i.e., 50 ₽.

2.3. Graphic Methods

• Fibonacci: Levels 38.2–61.8% help to define retest zones.
• Channels: Parallel lines through the peaks and troughs provide a visual boundary.
• Volume Profile: Identifies accumulation areas of major players.

3. Confirmation of Signals with Volume and Indicators

3.1. Volume Analysis

During the formation of the head, volume increases; during the right shoulder, it decreases, and during the neck line breakout, it rises sharply. This is the best visual indicator of reliability.

3.2. RSI

The pattern is often accompanied by bearish divergence in the RSI: the price forms a new high while the RSI shows a lower high.

3.3. MACD

Crossing the MACD signal line from top to bottom during the right shoulder or neck line breakout strengthens the signal.

3.4. ADX

A drop in the ADX below 25 during the formation of the right shoulder indicates trend weakness, while a subsequent rise after the breakout confirms the strength of the new movement.

3.5. Multi-Timeframe Analysis

Aligning signals on daily and hourly charts reduces the number of false breakouts and increases confidence in the signal.

4. Trading Strategies and Risk Management

4.1. Entering a Short Position

Enter after the close of a candle below the neck line with volume above the average of the last 20 periods. Alternatively, enter on a retest of the neck line during decreasing volume.

4.2. Stop-Loss and Take-Profit

Stop-Loss: 3-5% above the right shoulder or at ATR×0.5.

Take-Profit: Calculated based on the height of the pattern. Lock in 50% of the position at the first half of the target.

4.3. Trailing Stop

Move it behind each subsequent lower extreme to protect profits.

4.4. Scenarios

5. False Breakouts and Psychology

5.1. False Breakout

A brief breakout below the neck line without volume that quickly returns the price within. Filters include:

• Volume >120% of average.
• Closing of two candles below the neck line.
• Confirmation from RSI/MACD.

5.2. Psychology

The pattern reflects the shift in dominance from buyers to sellers. It is essential to avoid "fear of missing out" during the retest.

6. Inverted Model

6.1. Definition

The inverted "Head and Shoulders" forms at the end of a downtrend and signals the beginning of an uptrend.

6.2. Trading

Enter on an upward breakout of the neck line, set a stop-loss below the right shoulder, and set the take-profit based on the height of the pattern.

7. Practical Examples

7.1. Gazprom, Spring 2024

Shoulders at 300 ₽, head at 350 ₽, neck at 290 ₽. Neck line breakout with +180% volume → drop to 250 ₽ (−14%).

7.2. S&P 500, Autumn 2021

Shoulders at 4550 pts and 4600 pts, head at 4700 pts, neck at 4500 pts. Breakout → decline to 4200 pts (−7%).

7.3. EUR/USD, Summer 2023

Shoulders at 1.1000 and 1.1050, head at 1.1150, neck at 1.0950. Breakout → drop to 1.0750 (−2%).

7.4. BTC/USD, Winter 2022

Shoulders at $16,000 and $16,200, head at $16,800, neck at $15,800. Breakout with +institutional volume → drop to $14,000 (−12%).

8. Conclusion and Checklist

The "Head and Shoulders" pattern, with strict confirmation and risk management, is a reliable reversal tool.

• Identify the shoulders and head.
• Draw the neck line.
• Confirm volume and indicator signals.
• Enter after closing below the neck line.
• Set stop-loss above the shoulder, take-profit based on the pattern height.
• Utilize trailing stop and maintain a journal.

By adhering to this plan, you will effectively trade the "Head and Shoulders" pattern and minimize risks across any market.