Something that I’ve relied on over the years — and that has contributed to more than a few handsomerewards — is the Head and Shoulders pattern.
The Head and Shoulders pattern, quite simply, looks like a head and shoulders. When you look at a chart, you’ll know it when you see it!
But what does the Head and Shoulders pattern mean?
For me, it means it’s time to roll up the sleeves and start going to work—searching for options to buy puts on.
Of course, that’s not always the case. Sometimes the market just decides to move higher, and I get stopped out. I must say — it’s the worst feeling!
It hurts to lose on a trade when you’re doing something that is “supposed” to work. But sometimes the Head and Shoulders pattern is more complex than you realize.
I will explain to you a common setup, how it is used, and the pitfalls to avoid when trading it.
So before I get started, let’s review a quick head and shoulders reversal chart pattern.
It consists of four parts:
- The Left Shoulder
- The Center Head
- The Right Shoulder
- The Neckline
Here is a sample of what a Head and Shoulders pattern would ideally look like:
So what does a Left Shoulder, Head, Right Shoulder, and Neckline even show me?
Let’s analyze this textbook trade together…
Head And Shoulders Broken Down… Part by Part
It starts on the left shoulder. The market is strong and has experienced a natural pullback. At this point, there is no way to tell if the market will reverse! Remember, markets always make pullbacks quite regularly in an upward trend.
The market experienced a healthy rebound at this point. However, it is now common for buyers to liquidate positions and sellers looking to step in at recent highs, targeting the swing low that was formed from the initial pullback.
Pre-Right Shoulder (setup)
The sellers from the new highs have achieved their target, getting the price back down to the prior swing point.
To me, the pre-right shoulder is letting me know that a Head and Shoulders pattern may be coming soon and I will add this to my watch-list.
Prior to the right shoulder being formed, short traders are buying their short profitable trades back, and buyers are looking to step in at the resistance level that is being formed from the pivots.
The buyers make a final attempt to trade above a previous high, keeping the uptrend in place. However, the sellers stepped in and took control early, pushing the price lower towards the lows that are forming the Neckline.
This is the line in the sand for buyers. They must buy here to keep the uptrend going and achieve new highs in the stock price. If there is trading below this price level, the markets could find themselves heading lower with significant momentum and this will begin a downtrend.
A Head and Shoulders pattern is a possible trend reversal, signaling a failed uptrend and failed support. This is a prime level where sellers are looking to step in.
I hope you got into the short by using stocks or put options when this pattern triggered a huge move in the SPY’s. If you didn’t, click here to sign up for our daily alerts.
It was a textbook trade!
Most Common Head and Shoulders Pitfalls
So next, we will learn the biggest mistakes traders make when facing a Head and Shoulders pattern.
Let’s take a look at the two most common mistakes, and talk about how you can avoid them.
Keep in mind, not all Head and Shoulders are created the same. Some may be “wider” and some may be “taller”.
If you trade this pattern, pay attention to these two rules:
- The current market conditions and structure
- The duration(width) and height of the pattern
Let me explain why…
1. The Market Structure
The Head and Shoulders is a reversal pattern and tends to be traded in strong markets.
Unfortunately, if the markets are in a strong uptrend it could just keep going and cause you to step in front of a train.
Here is a Head and Shoulders pattern that caught me off guard. It was a good thing I had a stop right at the high that was made by the “Head” to keep losses to a minimum. The more “height” in the pattern usually means more risk in the event of being stopped out.
The underlying market structure was showing strength. It was a huge run-up in this stock and there was very unlikely that a simple chart pattern could have reversed that entire move. As expected, the market continued higher.
This one is tricky, but here‘s the thing…
A Head and Shoulders that takes 30-50 days to form is significantly more important than a Head and Shoulders that takes 5-10 days to form. I really love to trade a 30-50 day formation. It is even more powerful than ones that take 100-200 days to form! Even though it’s rumored the longer the better, that’s not always true for this pattern.
Why is that?
People, by nature, have ADHD. We are all distracted by the “breaking news” or something the president tweeted. Waiting 200 days for a pattern to unfold is not realistic. The SPY example above unfolded in just under 50 days, right inside out 30-50 day window!
Remember this for now:
If you want to find reliable or high probability Head and Shoulder trading setups, then you must pay attention to both the market structures and the duration of the pattern!
Now, this does not mean you should go short immediately when you find the perfect chart and the price breaks the neckline!
There are many “traps” that traders can get themselves into and next thing you know they are holding onto some major losses.
In the next article, look out for some of our explosive trades using breakout setups. Then I will explain how to trade the first pullback and reveal where I place my target exits and stop losses. Finally, I will share the five most common mistakes traders make when trading the Head and Shoulders pattern.
Stay tuned for more to come!