The Head and Shoulders Strategy for Investing

The head and shoulders chart pattern is well-known and easy to spot. It looks like a baseline with three peaks, with the middle peak being the highest.

On the head and shoulders chart, there is a change from a bullish to a bearish trend, which also shows that an upward trend is about to end.

The pattern can be used by all traders and investors because it shows up on all time frames.

Because the chart pattern shows important levels that are easy to see, it is easy to set entry levels, stop levels, and price goals for the formation.

Why Does the Head and Shoulders Pattern Work?

There is no perfect pattern, and they don't always work. But the chart pattern is true in theory for a number of reasons (we'll use the market top as an example, but it's true for both):

As prices fall from their market high, people are buying less aggressively (head). The market has also started to get sellers.

As the neckline gets closer, many investors who bought during the penultimate wave higher or during the right shoulder rally are now facing big losses because they were wrong. They will now sell their positions, which will push the price in the direction of the profit objective.

The head is higher than the right shoulder, so it makes sense to put a stop loss above the right shoulder. The trend has changed to going down, so the right shoulder is unlikely to be broken until the trend goes up again.

The profit goal is based on the idea that people who made mistakes or bought the security at a bad time will be forced to sell. This will cause a reversal that is about the same size as the recently formed topping pattern.

Many traders will start to feel pain at the neckline and be forced to close out their positions. This will move the price in the direction of the price objective.

You can also pay attention to volume. When there is an inverse head and shoulders pattern, we would like the volume to go up as the breakout happens (market bottoms).

Because there are more people buying, the price will move closer to the goal. Volume is going down, which shows that people aren't excited about the uptrend and calls for some skepticism.

Advantages

Traders who have done this before can easily spot it.

Stop distance, entry levels, and confirmation openings and closings can all be precisely set.

Since a head and shoulders pattern has a pretty long period, a market could move a lot between the price at which it opened and the price at which it closed.

The pattern can be used in both stock trading and foreign exchange (FX) trading.

Disadvantages

It's easy for new traders to miss: The head and shoulders pattern can happen even if the neckline isn't flat, which can be confusing for new traders.

If there is a big downhill movement for a long time, it is possible to stop from a long distance away.

If the price goes down, the neckline could be tested again, which could confuse some traders. If the neckline moves, the price could go up.