How the head and shoulders work in general

When traders and analysts watch the market, they are always looking for trends and patterns to try to predict how the price will move next.

To be successful at trading, you need to be able to find and correctly identify patterns and understand what they mean.

The head and shoulders pattern is important because it has been used by market analysts for a long time. Below, we'll explain what this pattern means and how you can make money from it.

What you need to know about the head-and-shoulders position

In technical analysis, the head and shoulders pattern is a chart formation that usually shows a change in the market's trend from bullish to bearish or vice versa. This pattern has been known for a long time as a good sign that a trend is about to change.

Before moving on, it's important to remember that the head and shoulders pattern is almost never perfect. This means that there will almost always be small price changes between the shoulders and the head, and the pattern itself is rarely perfectly shaped.

The Head-and-Shoulder Inverted Configuration

Head-and-shoulders patterns can also form in the opposite direction, showing a change from a downward market trend to an upward one.

This is called an upside-down head-and-shoulders pattern or an inverse head-and-shoulders pattern. It is just the opposite of the pattern we just talked about.

So, the inverse pattern shows that the market is changing from a trend of going down to a trend of going up.

With the inverse head and shoulders pattern, stock prices will drop to three lows, followed by two short-term price increases.

The deepest part is the middle valley, which is the head of the inverse pattern. The shoulders are a little less deep.

Once the second shoulder has formed and broken above the neckline, prices will stage a final rally. This will show that the bearish trend has changed and bulls are likely to take control of the market.

Pattern Interpretation

Traders like the head and shoulders pattern because it helps them figure out where prices will go once the pattern is finished and the neckline is crossed.

Traders can also easily put in stop-loss orders. When a head and shoulders pattern is present, stops are usually set above the head's highest point.

Stops are usually put below the low price formed by the head in an inverse head and shoulders pattern. When you look at the pattern again, measure the distance from the top of the head to the neckline to figure out how the price will move after the neckline is broken.

After the second shoulder forms, take the same distance away from the neckline in the opposite direction, starting at the point where prices crossed the neckline for the first time.

For example, if the price difference between the neckline and the top of the head is $20, analysts would expect the price to drop at least $20 below the neckline once the neckline is broken.

Even though this is just a guess, many traders think prices will drop by at least this much.

In a typical head and shoulders pattern, you would measure the vertical distance from the top of the head to the neckline. This would let you figure out the estimated amount of spread, as we've already talked about.

When looking at an inverse pattern, it's clear that the opposite is true. Find the vertical distance from the top of the head to the neckline to estimate how much prices are likely to go up after the neckline.

Using the Pattern as a Guide

Before trading, you must wait for a head and shoulders pattern to finish. Even if a pattern looks like it's forming or is in the process of forming, you shouldn't assume it will be complete and trade based on that.

The market can be unpredictable and change quickly, so watch for new trends and be patient. Don't overestimate what you can do.

Plan your trades ahead of time so you're ready to act as soon as the neckline breaks. Keep an eye out for things that could force you to change your entry, stop, and profit targets.

Traders often use a different entry point, but it requires them to do their research, be patient, and act quickly at the right time.

Traders who use this alternative method watch the pattern and wait for prices to move back up to the broken neckline level or just above it.

This is a safer trade that gives traders the chance to often get in at a lower price. But if you wait for a retracement that never happens, you might miss the chance to trade altogether.

Lastly, it's important to stick to trades that fit with how much risk you're willing to take and help you reach your trading goals. In the past, the head and shoulders pattern has been fairly accurate in a space that is known for being unpredictable.

It is also one of the chart patterns that is easiest to spot. No chart pattern is always right, but when the head and shoulders pattern correctly predicts a major trend reversal, it offers a big chance to make money.