Head & Shoulders Trading Strategy

Head and Shoulders Trading Strategy: Backtest and Example for a Tactical Approach

We were not able to 100% quantify a head and shoulders trading strategy. The formation is too difficult to put down into specific backtest rules. However, we were able to find some statistics done many years ago by Thomas Bulkowski and this serves as a proxy for our backtesting.

Some investors and analysts turn to technical analysis and chart patterns to analyze price movements and determine the right time to place their trade orders, and one of the most common chart patterns they focus on is the head and shoulders pattern. Let’s take a look at this chart pattern.

The head and shoulders pattern is a chart pattern formed by three consecutive price rallies and two intervening pullbacks, with the second rally being the highest among the three. The pattern, when seen in an uptrend, is considered a bearish reversal sign, indicating that the uptrend is about to turn into a downtrend.

Want to know more about this chart pattern, its inverse type, and how to analyze them? Keep reading.

What is the head and shoulders pattern?

A head and shoulders pattern is a chart formation used in the analysis of price movements to indicate a potential reversal in the direction of price. The pattern is based on historical price action — chartists study previous price swings to know if they form a shape that looks like a head with a shoulder on either side.

A typical head and shoulders pattern is characterized by an initial rally to a peak (the first shoulder) followed by a short swing low. This is followed by another rally to a higher peak (the head), and then, the price falls again to around the previous swing low before rallying to a third peak (the second shoulder) at about the same level as the first peak. Theoretically, this third peak (the second shoulder) indicates the end of the uptrend, as the price fails to make a higher high, and the potential beginning of a downtrend or a prolonged decline in price. But this cannot be confirmed until the price falls below the support level formed by the previous swing lows, also known as the neckline, which implies that the price has a consecutive lower high and lower low — the characteristics of a downtrend.

Thus, the head and shoulders pattern is a predictive chart formation that usually indicates a reversal in the trend, as the market makes a shift from bullish to bearish direction. It has long been hailed as a reliable pattern that predicts trend reversal. Both traders and analysts often use the pattern to determine primarily whether a downward trend is likely to take place. While the chart pattern is most commonly used on stocks, it is also popular in foreign exchange, commodity, and cryptocurrency trading.

What are the rules for head and shoulders?

These are some of the rules that qualify a head and shoulders pattern:

  • The pattern must form in a recognizable uptrend.
  • The second swing high in the pattern (the head) must be above the first and third peaks (left and right shoulders)
  • A line joining the intervening swing lows becomes the neckline, which is considered a support level.
  • The pattern is completed when the price declines below the neckline

But keep in mind that the head and shoulders pattern is almost never perfect, so there will likely be small price fluctuations between the shoulders and the head, and the shoulders may not end at the same level — the pattern formation is rarely perfectly shaped in its appearance.

What does the head and shoulders pattern look like?

Head and shoulder pattern
Head and shoulder pattern

The head and shoulders pattern consists of three price swing highs and two price swing lows between them. The second swing high is higher than the other two, and it is called the head. The first swing high is called the left shoulder because it lies to the left of the head, while the third swing high is called the right shoulder since it lies to the right of the head. A line connecting the two swing lows is known as the neckline, and it serves as a support level. The pattern is completed after the price breaks below it

Is the head and shoulders pattern bullish or bearish?

The head and shoulders pattern is considered a bearish reversal chart pattern. It is mostly formed at the end of an uptrend or an extended (multi-legged) pullback (a price rally) in a downtrend, so it indicates when an uptrend is about to turn into a downtrend or the continuation of a downtrend after a pullback. Since it is a bearish pattern, traders either use it to close their open long positions or take a short position in the market.

The pattern’s signal is confirmed only when the price breaks below the support level. This is when the bearish trend can be confirmed to have emerged — that is, a lower swing low has been formed in addition to the lower swing high that formed the right shoulder. It is this series of lower swing high and lower swing low that marks the emergence of a potential downtrend.

Some traders may trade the pattern at the level of the right shoulder if there is a bearish reversal candlestick pattern, such as the shooting star, bearish engulfing, and inside bar. For them, the lower swing high that formed the right shoulder already shows that the preceding uptrend is over, so they can look to book their profits if they have long positions or plan to sell short in anticipation of a downtrend.

What does an inverted head and shoulders mean?

The inverted head and shoulders pattern, also called a “head and shoulders bottom, is an inverted version of the head and shoulders pattern. It is mostly seen in a downtrend or a prolonged pullback (a price decline) in an uptrend. It is considered a bullish reversal pattern, as it indicates when a downtrend is about to turn into an uptrend or the continuation of an uptrend after a pullback.

Unlike the head and shoulders pattern, the inverse pattern consists of three price swing lows and two intervening price swing highs. The middle swing low is lower than the other two, and it is called the inverse head. The first swing low becomes the left inverse shoulder since it lies to the left of the inverse head, while the third swing low becomes the right inverse shoulder, as it lies to the right of the inverse head. A line connecting the two swing highs is the neckline, which serves as a resistance level. The pattern is completed only when the price breaks above the resistance line.

When the appears in a downtrend, it shows that the bears, who have been pushing the price lower, are now exhausted and getting overpowered by bulls, which is why the right inverse shoulder couldn’t fall below the inverse head and the price even rallied to break above the previous swing highs.

What is a head and shoulders reversal?

Head and shoulders reversal implies the reversal nature of the head and shoulder pattern or the inverse version. The classical head and shoulders pattern is a bearish reversal signal. When it forms, it means that the uptrend is likely over, as the last swing up (the right shoulder) couldn’t rise high enough to break the preceding high (the head) and the following decline could fall below the previous swing lows. So, the price is reversing to the downside.

Likewise, the inverse head and shoulders pattern shows a potential price reversal from a downtrend to an uptrend. The last swing low (the right inverse shoulder) couldn’t fall below the preceding swing low (the inverse head), which indicates that the downtrend may be getting exhausted. As the following swing high was able to break the previous swing highs, it shows that the price is reversing to an uptrend.

What are some head and shoulders pattern examples?

You can find many examples of the head and shoulders pattern on the charts of different assets, including stocks, futures, and currencies. Below are two examples of the pattern in Apple and Genesis Energy stocks:

Head and shoulder strategy example
Head and shoulder strategy example

The chart above is that of Apple.Inc (AAPL). You can see that the price was in an uptrend until it forms the head and shoulders pattern. Notice that the head is higher than the left shoulder and the right shoulder swing couldn’t sustain the upward momentum, indicating weakness in the uptrend. The price subsequently broke below the support level formed by two previous swing lows, and a downtrend emerged, even though the price rose again to retest the right shoulder resistance.

Head and shoulder strategy example
Head and shoulder strategy example

The chart above is that of Genesis Energy. A head and shoulders pattern formed in a prolonged price rally. After the price broke below the support formed by the neckline, a downtrend emerged.

What does head and shoulders target mean?

As with many chart patterns, the head and shoulders pattern can be used to estimate the profit target when trading the pattern. You can estimate the profit target by measuring the height of the head from the neckline and projecting it downwards from the neckline.  See the Genesis Energy chart again below:

Head and shoulder strategy (target)
Head and shoulder strategy (target)

From the chart, you can see that the same size of the head is measured downwards from the neckline to get an estimate of the price target. Interestingly, the price eventually fell below that target price.

Head and shoulders strategy (backtest)

This website is all about quantifying and backtesting. Unfortunately, the head and shoulder pattern is extremely difficult to put down into specific rules which you can backtest in any trading software. We use Amibroker ourselves, and we have managed to write a script that detects the head and shoulders pattern in a chart, but we don’t want to put in the time and effort to create a backtest.

Instead we rely on a semi-quantified backtest done by Thomas Bulkowski in his book from the late 90s called The Encyclopedia of Chart Patterns.

Bulkowski, an engineer, sat down and went through technical formations for 500 stocks over a period of five years. This gave a total database of 2 500 years, although of course there are sources of error as all the stocks are from the same time period. In total, he registered over 15 000 technical formations, of which heads and shoulders were some of these.

Bulkowki’s research revealed that the head and shoulders formation is probably the most reliable of all formations. The table below summarizes the facts of the survey:

DescriptionStatistics
#Formations among 500 stocks from 1991 to 1996431
Reversal or consolidation25 consolidations, 406 reversals
#False signals30 (7%)
Average fall after breaking down from the neckline23%
Most probable fall15 to 20%
#Formations that reached the target from the neckline254 (63%)
The average length of the formation52 days
#Pullbacks back to the neckline191 (45%)

The table indicates a reliable formation. Of course, this is not a formation that is 100 percent objective, but it is quite possible to draw some pleasant conclusions from this.

Out of a sample of 431, only 30 gave false signals (a false signal was recorded when the stock fell less than five percent below the neckline to then reverse upward). This gives a success rate of 93 percent. Bulkowski concludes that the formation is so stable that it is not necessary to wait for the stock to break down through the neckline. As soon as you have discovered a head and shoulders formation, you should therefore sell the stock or go short.

Note that most of the formations occurred after a period of upswing, and rarely (only 25 times) as part of sideways consolidation or continuation pattern on the way down. The average price drop was as much as 23 percent, which indicates that you can save a lot of money by selling off shares when you discover the formation. There are also many pullbacks back to resistance at the neckline, which is another opportunity to sell off the position.

Bulkowski claims that the volume has absolutely no significance for the formation’s success or not. Nor is it decisively important which way the neckline points, either up or down. Bulkowski suggests that a stop-loss can be placed directly above the right shoulder if you are shorting the formation

Inverse head and shoulders strategy (backtest)

You can also use the same methods from the head and shoulders formation to determine when inverse head and shoulders formations are interrupted. Thomas Bulkowski, in The Encyclopedia of Chart Patterns, has also collected data to check the reliability of the inverse head and shoulders formation. Here are Bulkowski’s findings:

DescriptionStatistics
#Formations among 500 stocks from 1991 to 1996330
Reversal or consolidation49 consolidations, 281 reversals
#False signals18 (5%)
The average rise after breaking the neckline38%
Most likely rise20 to 30%
#Formations that reached the target from the neckline258 (83%)
The average length of the formation73 days
#Pullbacks back to the neckline167 (52%)

There are relatively many formations in Bulkowski’s database and the statistics tell of a reliable formation with great profit potential.

It gives very few false signals, defined as stocks that rose less than five percent after the breach. Bulkowski writes that it is only possible to buy without waiting for the neckline to be broken when you see the formation establishing itself.

Worth noting is that you can expect between 20 to 30 percent in returns within 73 days. This is very impressive. It was only seven percent of the successful signals that gave less than ten percent in return.

Bulkowski believes that the stop-loss should be placed below the right shoulder. Alternatively, you can use the neckline as a stop. If the share falls below the neckline after a break up, the prerequisite for the purchase is gone.

The volume and direction of the neckline have no effect on the return, but the break through the neckline should come on a large volume.

Bulkowski concludes that the head and shoulders formation comes with some simple trading rules:

Trading Rules

THIS SECTION IS FOR MEMBERS ONLY. _________________ Click Here To Get Access Click Here To Get Access To Trading Rules

Head and shoulders trading strategy and Fed

Even the Federal Reserve in the United States has conducted surveys with positive conclusions using technical analysis, and especially the head and shoulders strategy.

In August 1995, the FED concluded the following in an article called Head and Shoulders: Not just a Flaky Pattern (Federal Reserve Bank of New York, Osler and Chang, Staff Report No 4 August 1995):

Technical Analysis…has been shown to generate statistically significant profits despite its incompatibility with most economists’ notions of “efficient markets.

Who argues against the FED?

Head and shoulders strategy – ending remarks

We were not able to develop a 100% quantified head and shoulders strategy.

However, Thomas Bulkowski’s statistics might show some light on the pattern and formation, but we are cautious. The reason is that Bulkowski used after the fact analysis. Thus, we strongly recommed to be cautious with the head and shoulders strategy, as we do with all technical analysis trading strategies. There is a reason why the name of the website is Quantified Strategies!

FAQ:

– What is the head and shoulders pattern in trading?

The head and shoulders pattern is a chart formation used in technical analysis to indicate a potential reversal in the direction of price. It consists of three consecutive price rallies and two intervening pullbacks, with the second rally being the highest among the three.

– How does the head and shoulders pattern signal a reversal?

In an uptrend, the head and shoulders pattern is considered a bearish reversal sign. It suggests that the uptrend is likely to turn into a downtrend. The pattern is completed when the price falls below the neckline, indicating a shift from a bullish to a bearish direction.

– What is the inverted head and shoulders pattern?

The inverted head and shoulders pattern, also known as the “head and shoulders bottom,” is the opposite of the regular head and shoulders. It is a bullish reversal pattern indicating a potential shift from a downtrend to an uptrend.

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