Today I will show you step by step how to trade the head and shoulders model.
In fact, I’ve even swapped many of the examples you’re about to see.
And I would like to emphasize one thing:
This is not just a guide for advanced traders. I’m a big believer in keeping things simple.
So, whether you’re just starting out or an experienced professional, you’ll love this guide.
Head and shoulders model attributes
Before you can trade it, you must first know the key attributes of the model. This way you can easily locate the most favorable head and shoulders to trade.
Let’s start with the illustration below.
As you can see from the drawing above, the head and shoulders model has five attributes.
In order of occurrence, they are:
- Upward trend
- Left shoulder
- Right shoulder
Note that I put the “neckline” last. At first, it may seem like a mistake.
However, we need both the shoulders and the head of the model before we can identify the neckline. If this sounds confusing, don’t worry. It will make more sense as you progress through the lesson.
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Now let’s discuss each step in more detail.
Step 1: Upward trend
The first part of a head and shoulders model is the upward trend. This is the highest extended movement that eventually leads to exhaustion.
As a general rule, the longer the upward trend lasts, the more likely the reversal is to be substantial.
Step 2: Left shoulder
The market moves down to form a higher minimum. At this point, things are starting to come together, but we don’t have enough to draw the neckline.
Step 3: Head
Now that the left shoulder has formed, the market makes a higher high that forms the head. But despite the bullish rally, buyers are unable to make a substantially higher minimum.
At this point, we have the left shoulder and the head of the structure. The neckline is also starting to take shape, but we need the right shoulder before we can draw the neckline on our chart.
Step 4: Right shoulder
The right shoulder is where things come together. It is an indication that buyers are tired and that the market may be preparing for a reversal.
As soon as the right shoulder begins, we have enough to start tracing the neckline. But since the model is not yet complete, it is better to think of it as a rough draft rather than a final version.
Step 5: Neckline
Now that we have a defined head and two shoulders we can draw the support of the neckline. This level will become a key component when we get into how to trade the breakout.
Think of the neckline as the line in the sand between buyers and sellers.
What causes the formation of a head and shoulders?
All price action carries a message. Some messages are easier to read than others, but they are always present.
As for the head and shoulders model, the message is that buyers are tired and that it is better to prepare for a potential reversal.
But what is in the model that reverses the market? How can some simple swing high achieve this?
These are the kind of questions that will help you unlock the clues and take you to the next level.
But there is a problem…
The way I formulated the two questions above fails to capture the essence of the head and shoulder pattern.
You see, it’s not the price structure itself that causes the market to reverse. It is the transition that occurs between buyers and sellers. The model is only the result or by-product of that process.
To explain things better, let’s look at it from a different perspective. For this, we will use a real head and shoulders formation that occurred on the GBPJPY weekly chart.
Note how after carving out a higher maximum (head) and pulling back, buyers were not able to push the price overhead. This eventually formed the right shoulder.
The lower maximum would be a big red flag if you were a GBPJPY bull during this time.
Let’s take another look at the same GBPJPY chart.
If you remember from the lesson on how to determine the strength of the trend, the telltale sign of an impending trend change is a shift in the sequence of ups and downs.
For example, a market that has carved out higher highs and lows could be in trouble with a single lower high.
However, a trend is not technically interrupted until we get a lower high and a lower low. Notice how the price action within the second red circle above eliminated the last oscillating low.
As soon as that minimum was lifted, the GBPJPY signaled that buyers were in trouble.
The inversion of the head and shoulders does not work because of the model itself. It works because of the way the ups and downs develop and interact with each other at the top of an uptrend.
Always remember to keep it simple. All we are doing here is identifying a potential trend change by focusing on the relationship between ups and downs.
Breakout head and shoulders
One important thing to keep in mind about the head and shoulders model is that it is only confirmed on a break in the neckline support.
And by pause, I mean a closure under it.
A common mistake among Forex traders is to assume that the model is complete once the right shoulder is formed.
In fact, it is complete and therefore tradable only once the market closes under the neckline.
Note in the illustration above that the market has closed below the neckline. This confirms the head and shoulders model and also signals a breakout.
Pro Tip: If you’re on the daily chart, you should wait for a daily close under the neckline before considering an entry.
Now let’s go back to our GBPJPY head and shoulders model example to see where it was confirmed.
Note how it took a daily closure under the support of the neckline to constitute a confirmed break. While there have been a few previous sessions that have come close to breaking the level, they have never actually closed below support.
Next, we will discuss some entry methods for trading the head and shoulders.
How to insert a break of the neckline support
So far in this lesson, we’ve covered the five attributes of a head and shoulders model. We also discussed how to differentiate a formation that is still intact from one that has broken.
Now for the really fun part – how to trade and, of course, profit from a head and shoulder reversal.
There are two schools of thought on how to get into a breakout. The first is to use a pending order to go short just below the neckline. Note that those who use this method are not waiting for the market to close under the neckline.
The problem with this approach is that you leave yourself exposed to the possibility of a false breakup. You will often see a pair fall below the support on an intraday basis only to close above the level again before 17:00 EST.
Which brings us to the second approach, and the one I prefer. This method involves waiting for a daily closure under the neckline before considering an entry.
In this way, you mitigate the risk of the market returning to your position and stopping you for a loss.
For this reason, we will only focus on the second approach. But even when you wait for the market to close below the neckline there are two entry methods to consider.
Let’s discuss each in detail.
Input method #1
The first way to get into a head and shoulders break is to sell as soon as the candle closes under the support.
For example, since we are analyzing the GBPJPY on the daily time interval, we would expect a daily close below the neckline. This would be our signal to go short (sell).
Here’s what it would look like:
Note how we are entering short as soon as the pair closes under the neckline support.
Input method #2
While the above method has its uses, I usually prefer to wait for a new neckline test as a new resistance.
This brings us to the second entry method.
Note how with the second entry method we are waiting for a new neckline test as a new resistance.
This accomplishes two things:
- Helps validate recent pause
- Offers a more favourable risk/reward ratio
This combination is why I almost always opt for the second method. There is, of course, a greater chance of missing an entry by waiting, but the potential reward for doing so is just as great.
Stop Loss positioning and risk control
Despite being simple, the placement of stop loss when trading the head and shoulders is a controversial topic. Some traders prefer a stop over the right shoulder, while others choose a more aggressive positioning.
Like everything you do in the Forex market, it’s about what works best for you.
That said, I tend to believe that a stop loss over the right shoulder is excessive. It unnecessarily and negatively affects the risk/reward ratio.
A head and shoulders is confirmed with a closure under the neckline, right? So a close return above the same level would undo the pattern.
Now, assuming my stop is above my right shoulder, will I wait for the market to take me out if it closes over the neckline?
Of course not.
So there are actually three ways to get out of the trade if things were to get tough. Let’s start with the first and, in my opinion, less appealing and then we will finish with my two favorites.
Stop Loss Placement #1
The first area where you can place your stop loss is above your right shoulder.
Note how this option provides a large amount of space between the entry and the stop loss.
However, this is not necessarily a good thing. I would also say that it does more harm than good. You see, such a high stop loss means that you have also halved your potential profit or worse.
In the case of the GBPJPY model the measured target, which we will come to later, is 1,800 pips below the breakout point. If you chose this first option to set the risk, it means that you would have a stop of 500 pips. If we divide it into the goal, we get 3.6R.
This is pretty good, but let’s see what we could have had using the section option.
Stop Loss Placement #2
This is my favorite stop loss placement. It allows a much better risk/reward ratio while still giving me the chance to “hide” my stop.
Here’s how it looks on the GBPJPY chart:
Note that I am placing the stop above the last swing high. This is still about 200 pips from my voice, so it’s hidden, but it’s not so far away that it negatively affects my potential reward.
You can always go tighter if you wish since it all depends on what suits your trading style. Just remember that the closer your stop loss is to your entry, the greater the chance of being taken off the trade prematurely.
Remember the profit of 3.6 R with the first stop loss placement above?
By setting your stop above the last swing high instead, you have reduced the stop loss distance from 500 pips to 200 pips. With a goal of 1,800 pips, this is an incredibly profitable 9R.
To put it in hypothetical terms, this is a profit of 7.2% against a profit of 18%, assuming you risked 2% of your account balance on the trade.
Exit Close (Safety Net)
I call it my safety net. Because any daily closure above the neckline suggests invalidation. And I don’t know about you, but I would rather take a loss of 50 pips than a loss of 100 pips.
Referring to the GBPJPY example above, if the market had closed again above the neckline after closing below it, we would want to exit the trade. Such a closure would signal that the model is no longer valid and that sellers no longer have control.
In fact, this notion can be applied to almost any model you trade. It can help reduce the size of a loss in case the market turns against you.
Head and shoulders lens
Knowing when to take profit can mean the difference between a winning trade and a losing trade. It is probably the most challenging aspect of trading.
When it comes to the head and shoulders model, there are two ways to deal with it. And for some, a mixture of the two may be the way to go.
The first and most conservative approach is to post profits at the first level of key support. These are the areas you have defined that could cause the market to rebound. Therefore, it may be a good idea to profit from a new test of one of these areas.
Because every situation is different, these levels of support can vary. But the only thing that must always be true is a favorable risk/reward ratio. So always make sure you do the math before you do the trade.
The second and most aggressive approach is to use a measured lens.
Although using a measured lens is more aggressive as your goal is farther from your entrance, it is also more universal.
Why, you ask?
When using this method, you perform a measurement of the height of the entire model. So regardless of the situation, you will always have a specific target area.
Here’s one from the EURCAD daily chart:
Note that I measure from the top of the head directly below the neckline. So I take the same distance and measure lower from the breakout point.
Measuring from this point is a small but significant detail, especially for the necklines that develop at an angle.
One last note on the measured goals. Although they can be extremely accurate, they are rarely perfect. So, as an additional layer of defense, it’s best to think of them as general areas rather than specific levels.
Also, try to find a key support level that intersects or at least approaches the measured target. This will help you validate the target area and give you a greater degree of confidence during the trade.
Who doesn’t like other examples? I know so.
So, to start wrap things up, here are a couple more examples of head and shoulders in action.
Be sure to take note of how each structure is formed in its own unique way but is still very effective in signaling a reversal.
The first is the EURCAD daily chart.
Note that in this case the measured target is aligned with a key rotation area. While not required, this can add a greater degree of confidence to any business idea resulting from the reversal.
The second reversal pattern was formed on the USDJPY weekly time frame after a multi-year upward trend.
A significant difference here from the first EURCAD inversion is that the USDJPY neckline is a horizontal level. This is perfectly acceptable but is not very common.
In most cases, the support of the neckline will form diagonally. The tone of the level may vary, but one thing must always be true: the layer should move from top left to top right. Note the corner on the first EURCAD chart above.
Key insights before you leave…
So, at this point, you are familiar with the attributes of the model, where to find it, and most importantly, how to get in and out for profit.
But there are some key insights I want to share with you before I go. Think of these as rules to follow when exchanging the head and shoulders model.
The pattern must form after an extended movement higher
This rule is self-explanatory. It can be a bearish reversal pattern only if it forms after a prolonged upward movement.
One way to double-check is to make sure there are no immediate swinging highs to the left of the formation.
Take a look at the charts above. Notice all the white space on the left. This is what you want to see when trading on any bearish reversal model.
Neither shoulder can be above the head
You can’t shrug your shoulders over your head, right?
For your sake, I hope not.
The same applies to this technical model. The head should always protrude over both the left and right shoulders. And while there is no exact rule for distance, it should be noticeable from a quick glance.
Pro Tip: If you have to question the validity of a model, it’s probably not worth the risk.
The neckline must be horizontal or ascending but never descending
If you find a head and shoulder where the neckline moves from top left to bottom right, you may want to stay on the sidelines.
For example, if you see this:
It is a sign of a “weak” reversal pattern. And while you may still enjoy a favorable outcome, the odds are not in your favor.
Instead, this is what you want to see:
Notice how the neckline is moving from left to bottom right. This suggests a “healthy” head and shoulders model and one you probably want to keep an eye on.
In my experience, the steeper the angle of the neckline, the more aggressive the breakout and reversal is likely to be. Look no further than the GBPJPY example above.
Shoulders should be in the same horizontal plane
This is a bit difficult to explain, so an illustration looks more appropriate.
Notice how both the left and right shoulders “overlap” to some extent. Each shares a portion of the same horizontal plane. They do not need to overlap completely, but they need to share a part of the area highlighted above.
If you find a pricing structure that doesn’t fit this description, it’s not technically a head and shoulders.
Stick to daily and weekly time intervals
Last but certainly not least are the times that tend to work better. After several years of trading these reversals, I can say with certainty that they are more reliable in the daily and weekly time frames.
While you can trade them on a 1-hour or 4-hour chart, you run the risk of finding a lot of false positives. This is a model that looks like a head and shoulder but does not behave like one.
To avoid this, be sure to stick to the daily and higher time period. After all, this is where you can usually find the most consistent trends.
There are many different ways to trade reversals in the Forex market, but few are as consistently profitable as the head and shoulders.
It’s not just about exchanging technical training. It’s about “reading” price action to understand the fundamental change between buyers and sellers.
While there are no guarantees in the Forex market, the head and shoulders strategy you just learned is as close as possible. Follow the above guidelines and you’ll be well on your way to making consistent profits.
What is a head and shoulders model?
The head and shoulders are a topping pattern, also known as a bearish reversal, in which the market makes a higher high (head) followed by the first lower high (second shoulder).
What makes the head and shoulders so effective?
A well-formed head and shoulders model protrudes like a sore thumb. It is also usually marked by the lower first high in an upward trend, which tends to attract sellers.
What does the neckline represent?
The neckline of a head and shoulders model connects the bass from both shoulders. It is the “trigger line” of the structure. A closure below confirms the reversal that tends to attract more sellers.
Where should a head and shoulders model develop?
Ideally, it should form after an extended upward trend. The higher the better. The more empty space you see to the immediate left of the model, the more likely it is that the model will unfold in your favor.
Now it’s your turn…
Are you ready to start trading the head and shoulder reversal pattern?
If so, you definitely want to download the free PDF of the head and shoulders template I just created.
It contains everything you need to know to maximize profits and minimize losses when trading. This includes how to get in, where to place your stop loss, measured goals, and much more.