Trading 101: Exploring the Popular Head and Shoulders Crypto Pattern

2021/12/08 10:50:22

The Head and Shoulders crypto pattern is commonly used among traders in crypto and traditional financial markets alike. When the price action forms this pattern, we can expect the trend to reverse from bullish to bearish.

How is the Head and Shoulders Pattern Formed?

This chart pattern has five components – a preceding uptrend, the left shoulder, the head, the right shoulder, and the neckline.

The Uptrend

The initial requirement for the formation of this pattern is a sustained uptrend. Remember that the Head and Shoulders pattern is a reversal pattern.

The Left Shoulder

After the sustained bullish trend, traders embark on profit-taking, which turns them into sellers in the market. This means that there will be net sellers in the market for a brief moment, resulting in a price pullback.

Note that at this moment, it is often impossible to tell whether the Head and Shoulders chart pattern will form because pullbacks occur regularly in a trending market.

The Head

After the initial pullback, short-term buyers return to the market to take advantage of the falling prices. This results in net buyers, pushing the prices upwards. This uptrend pushes the price beyond the peak formed before the initial pullback.

After reaching a new high, the price drops to the level of the first pullback when the left shoulder was formed. At the moment, we have a left shoulder and a head. The neck is also starting to take shape, but we need to wait for the right shoulder to appear before drawing the neckline.

The Right Shoulder

Formation of the right shoulder is when the complete pattern begins to take shape. The right shoulder is formed when the price rises again, forming the third peak, almost at the same level as the first peak where the left shoulder was formed. Note that the left and the right shoulder do not have to be on the same level.

The Neckline

The neckline in the Head and Shoulders pattern is a horizontal line connecting the support levels of the price pullbacks for the left shoulder, the head, and the right shoulder. This line is often used as the trigger entry for a short position.

In practice, the neckline doesn’t have to be a perfect horizontal line. This usually occurs if the right shoulder is higher or lower than the left shoulder. In this case, the neckline is slanting upwards or downwards.

How to Trade with the Head and Shoulder Pattern?

As we’ve mentioned, the Head and Shoulders chart pattern shows an imminent trend reversal from bullish to bearish. However, you must wait for the pattern to be formed fully before you decide to go short. So, where exactly do you short the market?

There is two way you can short the market, by using a conservative or an aggressive approach.

The Aggressive Approach

With the aggressive approach, traders short the market when the price drops below the neckline, which, as we’ve mentioned, acts as the support level. A break below this support level shows that the sellers are taking charge of the market, pushing the prices downwards, solidifying the bearish trend.

Here, the stop loss level is placed around the peak of the right shoulder. The logic behind this is that should the bears fail to take the prices downwards, then the price trending above the right shoulder means that bulls are still in control of the market.

Head and Shoulders Pattern Formation on the Bitcoin Price Chart | Source: BTC/USDT

The Conservative Approach

With the conservative approach, traders wait for the price action to break below the support level (the neckline) and then wait for a price pullback to retest the neckline. With this approach, we expect the neckline to be retested as a resistance level. It allows you to get additional confirmation of the recent bearish trend to avoid false breakouts. However, there is a possibility of missing the entry point if the price continues downward without a pullback. Similar to the aggressive approach, the stop loss is set around the peak of the right shoulder.

Bottom Line

The Head and Shoulders crypto pattern forms in an uptrend and signals an imminent reversal of the price action. This pattern is considered one of the most reliable chart patterns with fewer false breakouts since the support level has been tested at least twice with the pullbacks from the left shoulder and the head. A breach below the neckline acts as the trigger for short positions.

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