What is a Head and Shoulders Pattern?
Analyzing chart patterns is one of the most effective technical analysis tools in Forex trading. Head and Shoulders pattern is a good example of chart patterns. It helps a trader to identify possible reversals in an upward trend.
The Head and Shoulders Chart Pattern
The Head and Shoulders formation in forex trading occurs when a peak (the first shoulder) is formed, followed by a higher peak (the head), and a then a second lower peak (the second shoulder). This pattern is shown below.
From the figure above, the head is the middle peak, and should be the highest point in the pattern. The shoulders are lower peaks, which should not go to the level of the head.
The neckline is drawn by connecting the lowest points of the pattern as shown in the figure.
To trade forex using the head and shoulders formation, you should set your entry point where the prices break the neckline.
Inverse Head and shoulders
When the head and shoulders occur in a downtrend, it forms inverse head and shoulders pattern as shown below.
In this case, prices reach a low valley (shoulder) and rise shortly before dropping further to form the inverted head. Then it also rises and falls to a lower valley (the second shoulder).
In this scenario, the trader can place a buy entry just above the neckline.