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Spencer Li

Head and Shoulders Pattern Trading Strategy Guide (Updated 2021)

The head and shoulders and inverse head and shoulders are a type of common reversal pattern found at the end of major trends.

The bearish version is called the head and shoulders pattern, while the bullish version is called the inverse head and shoulders pattern.

In this post, I will show you how to take advantage of the head and shoulders pattern to identify major market reversals, and the best trading strategies for this price pattern.

If you would like to learn all the different price chart patterns, also check out: The Definitive Guide to Trading Price Chart Patterns

 

 

What is a Head and Shoulders Pattern?

The head and shoulders and inverse head and shoulders are another type of common reversal patterns found at the end of major trends.

When prices are unable to surpass the prior swing high (the head) and forms a lower high (the shoulder) instead, this forms the bearish head and shoulders reversal pattern.

When prices are unable to surpass the prior swing low (the head) and forms a higher low (the shoulder) instead, this forms the bullish inverse head and shoulders reversal pattern.

 

Head and Shoulders Pattern Psychology

Here is a quick recap of the 2 types of patterns:

  • Head and shoulders pattern – bearish reversal
  • Inverse head and shoulders pattern – bullish reversal

Head and Shoulders Pattern Psychology (Bearish Reversal)

In the head and shoulders pattern, bulls (buyers) are originally in control of the market, and the market is in an uptrend.

At some point in time, bears (sellers) try to take control, pushing down prices, which creates the “left shoulder” of the pattern.

Bulls resume control and push prices to new highs, which forms the “head” of the pattern.

Bears try to fight for control again, pushing prices back down to the level of its first push.

Bulls try one last time to resume control by pushing prices up, but it is unable to make new highs. This forms the “right shoulder” of the pattern.

Finally, bears take full control and push prices further down.

Bears are now in control of the market, and the market is in a downtrend.

Inverse Head and Shoulders Pattern Psychology (Bullish Reversal)

In the inverse head and shoulders pattern, bears (sellers) are originally in control of the market, and the market is in a downtrend.

At some point in time, bulls (buyers) try to take control, pushing up prices, which creates the “left shoulder” of the pattern.

Bears resume control and push prices to new lows, which forms the “head” of the pattern.

Bulls try to fight for control again, pushing prices back up to the level of its first push.

Bears try one last time to resume control by pushing prices down, but it is unable to make new lows. This forms the “right shoulder” of the pattern.

Finally, bulls take full control and push prices further up.

Bulls are now in control of the market, and the market is in an uptrend.

 

Head and Shoulders Pattern Trading Strategies

There are 3 main strategies, which focus on the taking advantage of the change in trend, and the difference lies in how early to enter the reversal when it happens.

  1. Early Entry: Enter immediately
  2. Pre-Breakout Entry: Enter immediately
  3. Pullback Entry: Wait for a pullback after the breakout

Since the head and shoulders is a reversal pattern, we can expect to see its swing counts change as the pattern unfolds.

For the bearish reversal of the head and shoulders pattern, we see the swing counts change from a series of higher highs and higher lows, to one of lower highs and lower lows.

For the bullish reversal of the inverse head and shoulders pattern, we see the swing counts change from a series of lower highs and lower lows, to one of higher highs and higher lows.

For all 3 strategies, they involve entering a position at various stages during this transition of swing counts.

Now, let’s go through each strategy in greater detail.

 

Trading Strategy #1: Early Entry

Our first strategy for the head and shoulders price pattern is to enter early as the 2nd shoulder (right shoulder) is forming, by using the 1st shoulder (left shoulder) as a guide.

As mentioned previously, the head and shoulders pattern is a reversal pattern, and we can expect to see swing counts change as the pattern unfolds.

The early entry takes advantage of this by shorting on the first LH (bearish H&S reversal), or going long on the first HL (bullish inverse H&S reversal). You can scroll up to the previous infographic (entries in head & shoulders pattern) to observe where the colour changes.

In the examples above, we see a prior trend, followed by the head and shoulders pattern which attempts to change the direction of the trend.

The first sign of the change of trend comes from the 2nd shoulder (right shoulder), because it is not able to reach the same level or exceed the head, which shows that the existing trend is weakening.

Most of the time, the 2nd shoulder (right shoulder) will form at roughly the same level as the 1st shoulder (left shoulder). This means that we can pre-empt the potential turning point of prices, and use that for our early entry.

For trading, we would look to enter near the point of the 2nd shoulder, keeping an eye for reversal candlestick bars/price action and volume which signals that momentum is weakening and it cannot go past the shoulder level.

We can then look to place our stoploss (SL) somewhere between the shoulder and the head levels.

This strategy works best if the price movement to resume the current trend is weak, and looks to be struggling just to touch the shoulder level, which suggests that it will most likely not be able to go past.

 

Trading Strategy #2: Breakout Entry

Our second strategy for the head and shoulders price pattern is to enter on the breakout/breakdown of the neckline.

As mentioned previously, the head and shoulders pattern is a reversal pattern, and we can expect to see swing counts change as the pattern unfolds, meaning a LH & LL if we want to short, and a HL & HH if we want to go long.

In the previous strategy (early entry), the entry was given on the first LH (shorting a bearish H&S reversal), or the first HL (going long on a bullish inverse H&S reversal).

In this strategy (breakout entry), the entry is given on the LL (shorting a bearish H&S reversal), or the HH (going long on a bullish inverse H&S reversal). Breaking the neckline automatically gives rise to a LL and HH respectively.

In the examples above, we can see the neckline (blue horizontal line) which denotes this crucial price level. Sometimes, if there is no clear neckline, this might result in a zone, or multiple necklines.

For trading, we would look to enter just as the breakout occurs at the neckline, keeping an eye for strong price action and volume which signals conviction in the breakout.

We can then look to place our stoploss (SL) somewhere between the neckline and the 2nd shoulder (right shoulder).

This strategy works best if there is a clear neckline which price is trying to break, followed by strong price momentum on the breakout.

If the price action is choppy/volatile, or if the neckline is not clear, then it would be better to wait for a pullback and use Strategy #3 (pullback entry) instead.

 

Trading Strategy #3: Pullback Entry

Our third strategy for the head and shoulders price pattern is to wait for the break of the neckline to occur (Strategy #2), then enter on the 1st pullback after that happens.

As mentioned previously, the head and shoulders pattern is a reversal pattern, and we can expect to see swing counts change as the pattern unfolds.

In the previous strategies, we shorted on a LH (Strategy #1) and LL (Strategy #2); or went long on a HL (Strategy #1) and HH (Strategy #2).

In Strategy #3, we will be shorting on the next LH (LH > LL > LH), or going long on the next HL (HL > HH > HL).

Therefore, since the new trend is slightly more established, the chance of success is higher, but the reward-to-risk ratio (RRR) will not be as good as the prior strategies. As we mentioned many times before, every trade is a trade-off between the hit rate and the RRR.

In the examples above, we can see where the 1st pullback occurs (yellow highlight), depending on which neckline you treat as the breakout.

Most of the time, the pullback will retrace to touch the neckline, but if the breakout momentum is strong, the pullback may not come all the way back to the neckline.

For trading, we would look to enter near the point of the pullback (usually near the neckline), keeping an eye for reversal candlestick bars/price action and volume which signals that momentum is weakening and it cannot go past the neckline.

We can then look to place our stoploss (SL) somewhere between the neckline and the 2nd shoulder (right shoulder).

If you have already entered a position during the breakout, this strategy can be an opportunity for you to add on more positions.

 

Profit Target for the Head and Shoulders Pattern

Once a head and shoulders pattern is completed, one of the most useful things about it is its ability to provide a price projection, which can be used to estimate a minimum profit target for your trade.

This can be done by taking the maximum height of the pattern (distance from the head to the neckline), and projecting that distance from the breakout point.

If the neckline is not clear or there are multiple necklines, it is advisable to go with the most conservative option, and use a smaller projection.

In the chart above, the maximum height of the head and shoulders pattern is indicated by the blue rectangular box, which is then used as a price projection at the breakout point.

The horizontal arrow indicates the price level which serves as the minimum profit target for the head and shoulders pattern breakout.

This price projection technique can be used in conjunction with other methods, such as support and resistance levels, and if there is any confluence, gives an added layer of confirmation.

 

Tips from the Trading Desk

  1. Make sure the trend is in the late stage – the longer the trend has been running, the more exhausted it is likely to be.
  2. Use the completed pattern for price projection – shoulders tend to be roughly the same height.
  3. The size of the pattern should be proportional to the trend it is trying to reverse.

As you can see from the chart above, this is an example of a strong trending market (3 green rectangle boxes), which ended in a head and shoulders bearish reversal (1 red rectangular box).

This means that for the whole move up, if we only measure the vertical distance (height), the trend accounts for 75%, and the reversal pattern accounts for 25%. This is within the healthy range, meaning the pattern size is proportional to the whole trend.

Typically, a reversal pattern works best when its height is about 25% to 33% (1/4 to 1/3) of the whole move.

If the pattern size is less than 25%, the pattern is too small to reverse the trend, which means that it might likely lead to a consolidation before the trend resumes, or the reversal pattern is still in the midst of forming, and might evolve to something bigger.

If the pattern is large than 33%, the pattern is too large to be classified as a head and shoulders pattern, and it could just be large swings within a wide range.

I have not come across any authors talk about price pattern proportionality in any books, but I see a lot of new traders making this mistake when trying to identify price patterns. And this applies to other price patterns as well.

Now that I have shared the various trading strategies for the head and shoulders price pattern, which is your favourite strategy?

Let me know in the comments below.

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Spencer Li

Cup and Handle Pattern Trading Strategy Guide (Updated 2021)

The cup and handle is an accumulation buying pattern, which is found during long periods of consolidation, and can lead to powerful explosive moves once the pattern is fully completed.

There are 2 main varieties of this pattern – the cup and handle reversal pattern, and the cup and handle continuation pattern.

In this post, I will show you how to take advantage of the cup and handle pattern to trade breakouts, how to avoid false breakouts, and the best trading strategies for this price pattern.

If you would like to learn all the different price chart patterns, also check out: The Definitive Guide to Trading Price Chart Patterns

 

 

What is a Cup and Handle Price Pattern?

The cup and handle is an accumulation buying pattern, which is found during long periods of consolidation, and can lead to powerful explosive moves once the pattern is fully completed.

In the diagram below, you can see that the price pattern consists of a larger accumulation base (the cup), before forming a smaller accumulation base (the handle), before finally leading to a breakout.

From a practical viewpoint, we will usually start to notice the pattern only when it starts forming the “cup” part of the pattern, which is quite identifiable by the smooth gradual curve upwards of trending swing counts of higher highs and higher lows on the chart.

The confirmation will come from the “handle” part of the price pattern, which is like a small pullback before the price explodes upwards. You can think of it as pushing down on a loaded spring, to build up more pressure just before the release.

 

The 2 Types of Cup and Handle Patterns

Unlike other chart patterns, the cup and handle pattern does not work equally for both the bullish and bearish scenario, as it is almost exclusively found in the bullish scenario only. Hence, we don’t hear people talking about “bullish cup and handle” or “bearish cup and handle”, because when they say “cup and handle”, it is understood to refer to the bullish version.

Based on the 2 main categories of chart patterns (continuation vs reversal), most people tend to classify the cup and handle pattern under the “Reversal Patterns” category, however I feel that the cup and handle can be both a reversal or continuation pattern.

In the diagram below, I illustrate the 2 different types of cup and handle patterns.

a) Cup and Handle Reversal Pattern

In the reversal cup and handle, prices start off in a prolonged downtrend, where they gradually lose momentum and become more sideways. Prices start to bottom out and form a reversal base, before leading to a change in direction.

b) Cup and Handle Continuation Pattern

In the continuation cup and handle, prices are on an existing uptrend, and when the trend loses some steam or takes a pause, prices start to move sideways. The cup and handle pattern helps to buy up more buying pressure, before prices break to new highs and resume the uptrend.

In both scenarios, the context is very different, but the pattern is the same, and can be traded in exactly the same way.

 

Cup and Handle Pattern Psychology

In the cup and handle pattern, as the downtrend starts to weaken (less bears/sellers), the bulls/buyers start trying to take control from the bears, by gradually accumulating long positions.

As they build up their positions, we start to see a wide U-shape bottom (the cup), where bulls and bears are almost balanced. This suggests that the bears are no longer in control, and the downtrend has been neutralized.

In the final stage, where the handle forms, this is where the final battle of the bulls and bears take place.

By this time, the bulls have the upper hand as they have been accumulating positions during the cup formation, which in turn attracts more buyers.

Once the last bears are killed, bulls take full control, and the explosive price breakout takes place.

 

Cup and Handle Pattern Trading Strategies

There are 2 main strategies, which focus on the final battle between the bull and bears, because that is usually the tipping point where large explosive moves happen once the bears give up and get overwhelmed by the bulls.

  1. Pre-Breakout Entry: Enter before the breakout
  2. Pullback Entry: Wait for a pullback after the breakout

Since the cup and handle is inherently a bullish pattern, the basic idea is to look for low risk buying opportunities to enter.

Looking at the diagram above, you might think that the best place to enter a trade is during the cup phase, because you can get the best entry price.

However, during the cup phase, the odds are 50-50, and there is no real edge, because the market is still sideways at that point of time.

In addition, the cup phase might last a really long time, and may not lead to a handle.

Hence, it makes more sense to make good use of your trading capital, and only enter the trade as the action is about to start.

The first opportunity would be to enter during the handle phase before the breakout, but if you miss that, they next best chance is to enter on the first pullback after the breakout.

Now, let’s go through each strategy in greater detail.

 

Trading Strategy #1: Pre-Breakout Entry

Our first strategy for the cup and handle price pattern is to enter just before the completion of the pattern, during the handle formation.

During the cup formation, buyers would have been accumulating long positions and building bullish pressure, with the occasional test of the resistance level by trying to break out.

As the handle forms, it is very close to the breakout happening, and this provides a good low-risk opportunity to enter the trade just before the action begins.

Once the breakout happens, the price and volume is expected to surge, which would make it more challenging to enter a position, hence it is recommend to take a position before that.

For trading, we would look to enter during the handle formation, which would be very close to the resistance level.

We can then place a stoploss below the handle, and since the handle is usually pretty small relative to the pattern, the risk will not be very high.

 

Trading Strategy #2: Pullback Entry

Our next strategy for the cup and handle pattern is to enter on the first pullback after the initial breakout.

As covered in the previous setup, one of the ways to trade the cup and handle pattern is to enter just before the price breaks out of pattern.

However, sometimes the breakout might be too fast, or you might have missed the breakout opportunity.

After such a long build-up (the cup and also the handle), it is very likely that any resulting move up would have more than 1 leg, so the first pullback/pause is a good place to enter because there is a high chance of a 2nd leg after the trend resumes.

In the example above, we see prices surge after the initial breakout, followed by a small pause which looks like a bull flag, before prices continue to surge again after breaking out from the flag pattern.

That small pause (in this case the bull flag) gives us a good low risk opportunity to get into the trade to ride the next wave of uptrend. Do note that the pause may not always be a flag, sometimes it might take other forms, but the idea is the same.

For trading, we would look to enter during the pause (formation of the small flag), when the risk and volatility is low.  The bottom of the pullback pattern would be a good place to put your stoploss.

If you have already taken a position using Strategy #1 on the pre-breakout, you can also use Strategy #2 to add more positions on the first pullback.

 

Profit Target for the Cup and Handle Pattern

Once the cup and handle pattern is identified, you can use the completed pattern to do a price projection, which can serve as a good estimate for a target profit for your trade.

To measure the target price, take the maximum height of the cup, and project that distance from the breakout point.

In the chart above, the maximum height of the cup is indicated by the blue rectangular box, which is then used as a price projection at the breakout point.

The black horizontal arrow indicates the price level which serves as the minimum profit target for the cup and handle pattern breakout.

To get an added layer of confirmation, you can look for confluence with with tools and methods, such as support and resistance levels.

 

Tips from the Trading Desk

  1. For cup and handle continuation, look to trade with the trend, especially if the trend is strong.
  2. For cup and handle reversal, look for a strong accumulation base to build the move.
  3. Look for multiple attempts to break the resistance, but also avoid the false breakouts!

As you can see from the chart above, a key component of the cup and handle pattern lies in the resistance level, because in a sense the whole build-up during the cup and the battle during the handle is an attempt to break though this level.

Hence during the build-up phase, we should look out for attempts to break the resistance levels, and it is expected that the first few attempts will fail, so do not try to trade those breakouts.

These “false breakout” attempts are more to probe for weaknesses, and the chances of a successful breakout at this point of time is low because there is insufficient build-up, which usually takes the form of the handle.

Hence, it is more prudent to only enter this setup during the handle formation, especially if previous attempts have been made to break the resistance.

Now that I have shared the various trading strategies for the cup and handle price pattern, which is your favourite strategy?

Let me know in the comments below.

/22 Comments/by
Spencer Li

Bitcoin – Breakdown from Triangle Pattern!

After months of consolidation, Bitcoin has broken down from its triangle consolidation price pattern.

The interesting thing is that if you look carefully you will see both a symmetrical triangle (neutral) and a descending triangle (bearish), so overall the odds of it breaking down was higher than the odds of it breaking up.

The next support level is around the $6800-$7000 level, so we might see a small pullback, followed by more bearish movement downwards.

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