One of the main aims of technical analysis is to provide traders with visual indicators to better read candlestick charts, and to identify trading opportunities. As such, indicators and especially price patterns and candlestick patterns are often named in a rather “visual fashion”. One of them, the head and shoulders price pattern, is a trend reversal pattern shaped like a head and two shoulders. It signals a downtrend. We’ll define the head and shoulders price pattern in this article and let you know how to spot one. Then, we’ll give you information on how to use head and shoulders price patterns for cryptocurrency trading.
What is the head and shoulders price pattern?
The head and shoulders price pattern is a technical analysis formation that predicts a reversal in the bullish-to-bearish trend. The pattern is formed when a stock’s price rises to a peak, declines back to the base of the prior up-move, then rises above the previous peak to form the “head” and then declines back to the original base. Finally, the stock price peaks again at about the level of the first peak of the formation before falling back down. The virtual line formed by the two lows of the pattern is called the neckline. The head and shoulders pattern is considered one of the most reliable trend reversal patterns.
On the picture above, you can see that the uptrend reaches a first peak, the first shoulder of the pattern. Then, a second higher peak is reached, the head, followed by a third peak of about the same height of the first shoulder. The pattern is followed by a downtrend.
How to trade with the head and shoulders price pattern?
When a head and shoulders pattern is spotted, the trader should first look for a breakout of the neckline. This is the point at which the trend reversal is confirmed and the trader can begin to execute a trade. The stop loss should be placed above the right shoulder. The profit target is generally the difference between the head and the neckline.
The example above is drawn from Binance’s BTC/BUSD market on a 1-hour timeframe. As you can see, the price forms a head and shoulders price pattern. Keep in mind that technical analysis is not an exact science. As such, patterns may not always come in a perfect shape. A short or a sell order can be placed upon confirmation of the head and shoulders pattern : when the price breaks from the neckline.
Using RSI and MACD to confirm a head and shoulders price pattern
There are many technical analysis indicators that can be used to confirm a head and shoulders price pattern. One of the most popular is the Relative Strength Index (RSI), which can help traders determine whether a security is overbought or oversold. Combining an overbought signal – RSI above 70 – with a head and shoulders price pattern is regarded as a best practice. Any other oscillator can work. Another indicator that can be helpful in confirming a head and shoulders pattern is the moving average convergence/divergence (MACD). The MACD can help traders identify when a security is reaching a critical juncture and may be poised for a large move. Look for a bearish signal given by the MACD to confirm a head and shoulders price pattern and go short. You might as weel look for a bearish moving average cross.