In technical analysis, traders interpret the head and shoulders formation as a strong sign that a trend reversal is in process.
Traders tend to focus too much on timing the right entry to a trade, but very few focus on developing a strategy for exiting positions. If one sells too early, sizable gains are left on the table and if the position is held for too long, the markets quickly snatch back the profits. Therefore, it is necessary to identify and close a trade as soon as the trend starts to reverse.
One classical setup that is considered reliable in spotting a trend reversal is the head-and-shoulders (H&S) pattern. On the longer timeframes, the H&S pattern does not form often, but when it does, traders should take note and act accordingly.
Let’s look at a few ways to identify the H&S pattern and when to act on it.
The H&S pattern forms after a bull phase and indicates that a reversal may be around the corner. As the name indicates, the formation consists of a head, a left shoulder, a right shoulder, and a distinct neckline. When the pattern completes, the trend usually reverses direction.
The above image shows the structure of an H&S pattern. Before the formation of the setup, the asset is in an uptrend. At the peak where the left shoulder forms, traders book profits and this results in a decline. This forms the first trough but it is not yet a strong enough signal to provoke a trend change.
Lower levels again attract buying because the trend is still bullish and buyers manage to push the price above the left shoulder, but they are not able to sustain the uptrend.
Profit-booking by the bulls and shorting by counter-trend traders pull the price down, which finds support near the previous trough. Joining these two troughs forms the neckline of the setup.
As the price rebounds off the neckline, the bulls make one more attempt to resume the uptrend but as the price reaches the height close to the left shoulder, profit-booking sets in and the rally fizzles out.
This lower peak forms the right shoulder and is usually in line with the left shoulder. The up-move reverses and the selling picks up momentum. Finally, the bears succeed in pulling the price below the neckline. This completes the bearish pattern and the trend reverses from bullish to bearish.
Spotting trend reversals with the H&S pattern
Bitcoin (BTC) started a strong up-move after breaking out at $20,000 in December 2020. The BTC/USDT pair hit a local peak at $61,844 on March 13 and the price corrected, forming a trough on March 25. This local peak was the left shoulder.
The bulls considered the dip as a buying opportunity because the trend was still up. Aggressive buying then pushed the price above $61,844 and the pair hit a new all-time high at $64,854 on April 14. This level attracted selling, which pulled the price down to form the second trough on April 25. The middle peak, higher than the other peaks, formed the head.
Another attempt by the bulls to resume the uptrend failed on May 10. This formed the right shoulder and the ensuing correction broke below the neckline of the pattern. The breakdown and close below the neckline on May 15 completed this bearish setup.
Sometimes, after the breakdown, the price retests the breakdown level from the neckline but when the momentum is strong the retest may not happen, an example which is shown in the chart above.
To calculate the pattern target of this setup, determine the distance from the neckline to the top of the head. In this case, the value is $15,150. This distance is then subtracted from the breakdown point on the neckline to arrive at the minimum target objective.
In the above example, the breakdown happened close to $48,000. This projected a pattern target at $32,850. This figure should be used as a guide because sometimes the decline exceeds the target, and in other scenarios the down move ends without reaching the target objective.
Head-and-shoulders sometimes fail
Sometimes traders jump the gun and take counter-trend positions before the price breaks below the neckline of the developing H&S formation. Other times, the break below the neckline does not see follow-up selling and the price climbs back above the neckline. These instances may lead to failed setup, trapping the aggressive bears who are forced to cover their positions and this results in a short squeeze.
Cardano (ADA) started an uptrend from the $0.10 level on Nov. 20, 2020. The uptrend hit resistance in the $0.35 to $0.40 zone in January and a H&S pattern started developing. The price dipped to the neckline on Jan. 27, but the bears could not sink and close the ADA/USDT pair below the support.
When the price rebounded off the neckline on Jan. 28, it was a signal that the sentiment remained bullish. There was a minor hiccup on Jan. 30 and 31 when bears attempted to stall the up-move near the right shoulder but sustained buying from the bulls pushed the price above the head on Feb. 1. This break above the head of the pattern invalidated the setup.
When a bearish setup fails, it catches several aggressive sellers on the wrong foot. This results in a short squeeze and propels the price higher. The same thing happened in the above example and the pair soared in February.
The H&S pattern is considered a reliable reversal pattern but there are some important points to bear in mind.
A downward sloping or flat neckline is considered to be a more reliable pattern compared to an upsloping neckline. Traders should wait for the price to break down and close below the neckline before initiating trades. Pre-empting the setup could result in losses because a failed bearish pattern could result in a strong rally.
The pattern targets should only be used as a guide because sometimes the price may overshoot and continue the down move and at other times it may reverse direction before reaching the target objective.
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