Head and Shoulders figure: concept, technical analysis, trading, psychological model of market players

Technical analysis of financial markets includes many models that can predict further price movements. The figure “Head and Shoulders” is one such. Despite its more than three hundred year history, it is still a reliable tool.

Building a graphic model “Head and Shoulders”

The “Head and Shoulders” figure came from Japanese candlestick analysis. It works regardless of the type of chart display. This pattern can be either a bullish or a bearish pattern. In the case of a bullish pattern, it is called “Inverted Head and Shoulders”. Japanese analysis calls the “bear” model “Three Heads of the Buddha”, and “bullish” the “Three Rivers”.

Technical analysis answers the question: what is happening on the market at a particular moment in time, will there be a price reversal or will it continue to move? This model belongs to the first option. There are several similar reversal structures: “Three Peaks”, “Two Peaks”. They are also often found and formed at the places where the trend ends.

“Head and Shoulders” consists of three price formations resembling a dome. Moreover, the average will be the highest - he is the head. The two peaks on the sides will be shoulders. They are much smaller in size.

If you draw a straight line from the base of the first peak to the base of the third, then this line will be called the "neck". In the rules of trade, it plays an important role.

An ideal figure is when the shoulders are symmetrical, but in practice one of them is taller and wider than the other, and the neck may have a slope.

The figure of the “Head and Shoulders” technical analysis is considered formed if a straight line can be drawn on the chart.

Inverted model

The inverted “Head and Shoulders” is less common. It is also formed by three peaks, but directed downward. This design occurs after a long downtrend. The construction of it is completely identical to the inverted model.

Pattern Features

If a “Head and Shoulders” figure appears on the technical analysis chart, you need to pay attention to several points:

• There should be a long previous trend. Ascending for the bearish and descending for the bullish.
• The more pronounced parts of the pattern, the higher the probability of its development.
• Symmetry both in height and in duration in time is also a good indicator.
• The model can be used in trade only after breaking through the neck level at the price.
• The higher the timeline, the more hope for this pattern. Cases below H1 are best avoided.
• A confirmation for this model will be divergence, that is, a discrepancy between two lines: a trend drawn along the tops of the figure, and a second drawn along the peaks of the histogram of the MACD indicators or volumes.

• The goal that you can count on when working out the “Head and Shoulders” figure is equal to the distance set aside from the top point of the head to the base of the shoulders.

The causes of the model

The emergence of this model is due to the psychology of bidders. What does the “Head and Shoulders” figure mean?

First, the price moves in a certain corridor, which forms a trend. This movement lasts long enough. And the longer, the stronger the market participants begin to expect a reversal. When it comes to a strong resistance level, traders try to close long positions. The decline in volumes forces the price to roll back to support, which had previously been resistance. This forms the left shoulder.

However, not all market participants are willing to sell at the resulting price. Seeing that it does not move further down, traders reopen purchase transactions, forcing it to go up again. Seeing that the movement began again, the latecomers jump into the “departing train”. They do this at a time when large players, on the contrary, begin to close long positions. Price ceases to rise and gradually decreases. Latecomers close at a loss, panic begins.

Here, at the largest peak, there is no longer any purchase volume, and since the level that has arisen is very attractive for sales, more short positions are opened. Price drops to the resistance line formed by the base of the left shoulder. It does not work out right away, so the movement stops again. The head is formed.

A small group of players, encouraged by the stoppage, again begin to open buy positions. But a small number of them cannot push the figure above the level of the left shoulder.

When the price drops back to the resistance level, sellers already understand that the market rejected it and it will fall. The right shoulder has formed, and a large number of players are willing to sell. With the arrival of large volumes, the price begins to fall rapidly, making it possible to earn.

Pattern Trading Options

Trading the figures “Head and Shoulders” can be divided into three options:

• classical;
• aggressive;
• conservative.

They differ in different approaches. Therefore, the degree of risk will also be different. This does not mean the probability associated with the conclusion of the transaction, but with whether this pattern will be worked out.

Aggressive Trading

The aggressive method is that the transaction is opened before the model finishes its formation. At that moment, when it’s still impossible to say exactly that on the Forex chart the figure “Head and Shoulders”. As you know, it finishes its formation only with breaking through the price level, which forms the neckline.

In the case of an aggressive approach, a deal is opened at the moment of growth of the right shoulder. The advantage of this method is a significantly larger amount of profit than in classical trading. The downside will be a big stop loss. It will need to be installed behind the top, which is the head. This is quite a lot. The ratio of risk to potential profit is reduced. In addition, since the figure is not fully formed, a trend reversal and continuation are possible.

Classic trade

The standard entry into the transaction occurs during the breakdown at the cost of the base of the figure “Head and Shoulders”. In this case, stop loss is set above the upper level of the right shoulder, and take profit is placed at a distance equal to the height of the model, laid down.

But there is another way to enter the deal. This method has the most minimal risks. Its essence is to enter not during the breakdown of the shoulder, but at a retest. In this case, after breaking through, you need to wait for the price to return to the neck level. Then wait until she pushes off, and then open a sell position. Although this method minimizes risks, there is a chance that the price will not go to a retest level, but will immediately begin to move down.

Indicator for automatically finding the “Head and Shoulders” pattern

If at the initial stage it is difficult to identify such a technical analysis figure as “Head and Shoulders”, the Head & Shoulders Dashboard indicator will help to find it. He shows it on any timeline.

After installing the indicator in the trading terminal, it will display a table with the figures “Head and Shoulders” on all instruments that are specified in the settings. That is, you can automatically track different currency pairs. By clicking on the selected tool, the user will see a graph with the pattern found.

In the Metatrader 4 terminal, the indicator is installed as standard. In the "File" menu you need to open the data directory. Select the MQL 4 folder in it. Find the Indicators directory in it. There you need to unzip the indicator files.

Indicator settings

After rebooting the terminal in the navigator menu, select Head & Shoulders Dashboard and drag it into the chart window. After that, the indicator settings dialog box opens:

• Symbols - a list of available tools;
• Is ... Timeframe Enabled - a function that enables searching on a given timeframe;
• Sort By - by what criteria to sort;
• Sort Type - distribution type;
• Price Proximity Percent - setting search accuracy;
• Fill Patterns with Color - how to display a pattern on a chart: with or without color filling;
• Display Head and Shoulder - setting the display of “Head and Shoulders”;
• Display Reverse Head and Shoulder - enable the display of an inverted model;
• Depth, Deviation, Backstep - setting associated with the Zigzag indicator;
• Alert Title - alert title;
• Popup Alerts - a signal given when a new pattern is found.

After the notification appears in the trading terminal, the task of the trader is to determine where the indicator found the “Head and Shoulders” figure. According to technical analysis, it can occur after a long trend. The movement must be at least 100 candles, regardless of the timeframe on which the figure is found. If the pattern arose in price consolidation, then there is no reversal. Accordingly, this situation is not considered as a trading signal.

Conclusion

The “Head and Shoulders” figure in trading is quite common. But not every one of them needs to be considered as a source of a profitable deal. Any graphic design needs confirmation, as well as amplification with additional signals. Then the risks associated with unprofitable transactions can be minimized.