Dennis Y.Tue, Dec 21, 2021 5:05 PM
Crypto Trading ABCs: Head And Shoulders Chart Pattern Full Guide
In our latest review, we already started studying core patterns and setups. Let's talk about a vivid and popular figure, which got its name thanks to its typical build. You may know it as "Head and Shoulders".
This figure is quite interesting because during the uncertainty in early December 2021 some experts saw this formation in Bitcoin's movement (we will mention it later).
Ideally, the analysis of the patterns applied to the current situation is combined with the fundamental methods. Otherwise, predictions are not trustable.
On an uptrend, the normal Head and Shoulders figure is considered, while on a falling trend, the Inverse Head and Shoulders type is applied.
The appearance of this figure indicates a violation of the established trend and the possible price pivot motion.
As a rule, this figure reveals the forthcoming price decrease, when the price slips under the zone of neck/support. Some experts describe this formation as a bubble indicator. Figures like these are most often formed during a hype bubble (related, for example, to some tokens in interest).
That is how the Bitcoin graph behaved during the cryptocurrency boom in 2017 or how DeFi tokens, which experienced a substantial correction after a staggering growth.
Normal Head and Shoulders
As noted, this shape appears to be a pivot one, and it reorients us to a bearish approach after a previous growing momentum. It is composed of 3 vertexes:
- the head (maximum apex)
- left and right shoulders (lower apexes)
The height of the shoulders may vary slightly, not being strictly flat.
Let's describe this figure in simple words: the price was about to break the pre-maximum, but failed. It describes how the impulse became exhausted. There is no magic, just the usual reasoning, and factors of asset (BTC, or oil, or gold, or EUR, doesn't matter) motion. So, it's a possible sign of the trend's imminent transformation.
Inverse Head and Shoulders
This shape often may appear as a bullish one, emerging after a downtrend. It gives a sign that the descent comes to its final stage, and the ascent begins (probabilistic).
It's a mirror version of the normal pattern, but the shoulders and head are pointing down. It is observed in a downtrend (see chart below) and may portend an upcoming change to the opposite market state (as the classic figure does).
TradingView has a handy template tool that helps you to recognize this shape on the particular token chart.
How to Recognize Head and Shoulders Patterns
The shape definition for different assets (crypto, stock, fiat currencies) is identical. It marks this figure as a universal "magic wand" for almost any scenario.
The main points:
- Determine the general trend (up or down).
- Identify the 3 subfigures.
- All three parts should be as symmetrical as possible, at a relatively equal distance from each other
- Find the zone of the neck at the lowest local position in the area between shoulders. Ideally, you will have a horizontal line or a line with a slight slope to one side or the other.
This algorithm works for determining both standard and inverse figures.
Important note: If such a shape is constructed during sideways movement (including very prolonged ones), it can't be regarded as a pivot shape.
What Traders Can Utilize Head and Shoulders Chart Pattern
This is a favored pattern, which is often believed to be one of the most eloquent of all the shapes that anticipate a possible trend change. It is good because it gives quite a clear understanding of the possible entry, exit points, and risks.
5 Steps of Determining Head and Shoulders and the Peculiarities on an Uptrend
- The current "hill" on the chart generates the left shoulder.
- After the recent maximum, the price violates the trend movement. After the completion of the correction, we can find the head. It's a strong impulse within the current trend. It sets the one more maximum, nevertheless, the price immediately rolls to its beginning. So it becomes obvious that the bullish trend is weakening.
- Shaping the right shoulder. The price chart is trying to climb higher, but it still does not exceed the last spike. It is meant to have a similar shape as the left one, but in fact, it seldom happens.
At this stage, market players who are determined to buy still have enough strength to make an attempt to rectify the situation and cause the price to move up. But the weak potential of buyers' force causes the price to reach a new (but a bit lower) maximum, with an obligatory rollback.
- A descent below the neckline. After price "retreats", it approaches the neckline, which is built from the lowest areas of the shoulders and the head. The neckline may be ascending, horizontal, or descending, depending on the balance of 2 main armies: "bulls vs. bears". The classic sell setup appears when the price performs a downward breach of the neckline.
- Focusing on closing the deal. It is recommended to close the position with profit after the price overcomes the way equal to the segment from the maximum of the head to the neck level. In order to determine these indicators more accurately, it is better to add other tools: support/resistance lines, Fibonacci levels, and MA.
If all signs are formed, it means that we observe the complete figure.
Let's underline: the important condition is necessary for its effective use. Observe the line drawn on the price minimums - neckline. Breakdown of this line indicates a probability of price fall. Active traders strive to put their orders at this point. After a breakdown of the neckline, the price often comes back to it (retest). The rebound from it may be considered as an additional confirmation of the fall, and there is a chance to join the movement.
If no rebound is found, the figure is broken. In the face of such uncertainty, it is better not to rush into action and observe.
There is one more positive feature of this figure, which allows you to find more or less clear price limits for your SL/TP orders. This feature is also common to some other figures and can be helpful to understand where we should think about fixing the profit (don't forget: it's just a probability).
Another property of the figure is noted in the classic business literature: the larger the model is in breadth and width, the more significant the subsequent movement may be.
The best approach is to look at large timeframes - daily (D), weekly (W). On smaller intervals (less than daily), this figure is less relevant.
On a falling trend, the properties and mechanics demonstrate absolute opposite ways to proceed.
Three Market Approaches with Head and Shoulders Pattern
In this case, you enter at the level of the second shoulder. The potential returns are higher here, but the risks are also higher because there is uncertainty and the probability that the figure will not finish its creation.
You enter with the breakout of the neck zone, with a tangible risk that it's just manipulation or a false breakout. So do not forget to put SL.
There is less profit, but less risk. The main idea lies in the fact that usually after reaching an important zone, the price makes a retest. It is on the retest (the line of the neck) that conservative participants enter (with proper and well-balanced risk management, of course). However, this next entry point may be absent.
For the inverse head and shoulders figure, these methods are mirrored.
Pros and Cons of the Head and Shoulders Pattern
- Easily detected by experienced market players
- More or less obvious risk and profit areas
- The decent chances of getting profits, caused by large price movements
- Suitable for all types and states of markets
- For newcomers, it is tricky to catch it just in time
- The determining candlestick may close far lower than the neck zone is situated. It may require you to revise your SL levels
- Price retest may be confusing to inexperienced market players
- The overall risk/rewards ratio related to this approach may not satisfy a trader
What About Head and Shoulders Pattern with Bitcoin Uncertainty in November-December 2021?
In early December 2021, Bloomberg published a piece in which experts were talking about possible elements of this very pattern, and expressed fears of facing a significant fall and catching "falling knives".
However, we should not rush to conclusions. After two weeks after the publication on the 4H timeframe, we can find another figure - Falling Wedge. A pretty obvious one. It often breaks to the top, but once again - not 100%.
The Head and Shoulders Pattern is outstanding and logically illustrates the price motion and pivot points in different tendencies. It can help you to navigate the market. However, further balance or imbalance is not a certainty but a probability.
The information presented in this piece is not a call or recommendation for action. When deciding to trade in the financial markets, you should 100% comprehend and assume all the risks.