What’s a Head and Shoulders Pattern?

FX Strategy Articles > Technical analysis articles

In technical analysis, you will often hear traders talk about the head and shoulders pattern. But what do they mean exactly when they talk about that?

As the name would suggest, a head and shoulders pattern is a pattern on the chart that resembles—you guessed that right—a head and a pair of shoulders. Basically, it follows the following pattern:

1.    A rise to an initial peak (forming the left shoulder) which then drops
2.    Prices rise again to a second peak but at a level higher than the initial peak (forming the head), then drops again
3.    Prices see another rise (forming the right shoulder) but not as high as the second peak, and then drops

The lowest prices reached in between peak 1 and peak 2, as well as peak 2 and peak 3 form what is called the neckline. The head and shoulders pattern is then confirmed when the lowest price after peak 3 breaks through the neckline.

But that’s just the basic head and shoulders pattern, which is also called the head and shoulders top. There is also the head and shoulders bottom, which shows a reverse pattern. While the top pattern indicates an eventual drop in prices (after the peaks are reached), the inverse or bottom indicates a rise in prices. Here is the typical pattern of a head and shoulders bottom:

1.    Prices drop to a new low (creating the left shoulder) then rises again
2.    Prices drop lower than the left shoulder (which forms the head), and then rises
3.    Prices drop one more time (forming the right shoulder), before rising again.

Understanding patterns like this helps you as a trader to make informed decisions when it comes to buying or selling currency. For example, when the prices break through the neckline in a head and shoulders top pattern, it could tell you that the price of a currency is on its way to a new low. You could then decide to start selling off currency if you have it, or start buying it at low prices. Though this is not always the case (as prices could immediately go on an upward trend after dropping), but what we’re trying to do is to merely illustrate how understanding patterns can help you when you trade.

For more  tips, please check out our Technical analysis articles section.

By FX Strategy Team, Published on 16th of April 2013
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