“Head and Shoulders” patterns are reversal formations that usually form at the market tops. “Head and Shoulders” patterns are very reliable, but failures do occur. When Head and Shoulders patterns fail, they reverse the pattern and trade in an explosive manner. Most “Head and Shoulders” patterns can be detected using volume patterns. During the left shoulder and the beginning of the “Head formations, the volume will be heavy. While forming, volume dissipates on the right shoulder, and the volume increases during the breakdown.

A trend line or neckline is drawn connecting the “Head and Shoulders” pattern to determine the potential trade opportunities and targets. The neckline can be also formed in an angle (slanted).

Trade: Connect “Head and Shoulders” bottoms in a trend line or neckline. When the price closes below the neckline, a potential short trade is signaled. Short one tick below the breakdown bar’s low.

Target: Compute the vertical distance between the “apex” of the “Head and Shoulders” pattern and the neckline. The target is set below this distance from the neckline.

Stop: After a trade entry, if the price closes above the neckline, a potential failure of the pattern is signaled. Place a “stop” order above the neckline.

Trading Head and Shoulders Pattern

Trading Head and Shoulders Pattern

The example above shows a “Head and Shoulders” pattern formation from the Russell Emini (ER2) 30 minute charts. From January 1 1 to January 17,2007, the pattern formed “Head and Shoulders” pattern. A neckline was drawn connecting the bottom of the two “shoulders” to signify the potential breakdown trade. On January 18, ER2 closed below the neckline to confirm a breakdown.

  1. Enter a “short” trade below the low of the breakdown bar at 794.
  2. Target 62% to 100% of the pattern depth (14 points) from the breakdown level at 794.
  3. Place a “stop” order above the neckline at 796.

Trading Inverse Head and Shoulders

Trading Inverse Head and Shoulders Pattern

The example above illustrates the “Inverse Head and Shoulders” pattern formation from Microsoft Corporation’s daily chart. In anticipation of Microsoft’s Vista Operating System, investors drove the stock upside from August to December 2006. A neckline is drawn connecting the “Head and Shoulders” swing highs. In late July, Microsoft traded above the neckline and signaled a potential long trade.

  1. Enter a “long” trade above high of the breakout bar at $24.
  2. Place a “stop” below the right shoulder at $22.
  3. Target the depth of the “Head and Shoulders” pattern ($3) from $24 to $27.

Trading Head and Shoulders Failure

Trading Head and Shoulders Failures Pattern

The chart above illustrates an example of a “Head and Shoulders” pattern failure. A trend line I is drawn connecting the bottoms of the “Head and Shoulders.” The “Head and Shoulders” failures occur when prices failed to close below the trend line.

  1. Enter a “long” trade above the “high” of the right side shoulder.
  2. Place a “stop” order below the neckline for trade protection.
  3. Target the depth range from head to the neckline from the trade entry.

Trading Head and Shoulders Failure

Trading Head and Shoulders Failures Pattern

The example above illustrates a “Head and Shoulders” pattern failure from the Russell 2000 Emini chart. On April 4 2007, ER2 formed a “Head and Shoulders” pattern with inclined (slanted) neckline. On April 5 2007, a trend line breakdown is anticipated for a “Head and Shoulders” pattern. This pattern is an example of reversal formation as “Head and Shoulders” pattern failed and continued in a reverse direction from the previous trend.

  1. Enter a “long” trade above the high of the right side shoulder.
  2. Place a “stop” below the low of the prior swing before the trade.
  3. Target 100% of the depth of the “Head and Shoulders” pattern from the trade entry.