Interpret Head and Shoulders and IHS Reversal Patterns
They’re easy to spot and widely used by cryptocurrency traders. Both Head and Shoulders and Inverted Head and Shoulders patterns are reliable indicators of the bullish-to-bearish trend reversal or vice versa.
Both chart patterns are also easy to implement in trading strategies. as they show clear entry levels, stop levels, and price targets.
Read below for a detailed explanation of how to interpret both patterns.
How to Interpret the Head and Shoulders Pattern
Understanding the Head and Shoulders pattern begins with identifying its elements: three peaks, with the middle one being the highest and the other two being roughly equal.
However, the key to making informed decisions is the effective interpretation of this pattern.
Here's how to do it:
When the pattern is complete, it suggests a reversal from a bullish trend to a bearish one.
You need to get the confirmation of a neckline break. The neckline is a level of support or resistance that can help traders identify strategic areas to place orders. In a standard head and shoulders pattern, which is typically seen at market tops, the neckline is drawn by connecting the low after the left shoulder with the low formed after the head. This creates a horizontal line that acts as a support level.
Wait for the price to break below the neckline to confirm the validity of the pattern. This breakdown indicates a potential bearish trend reversal, signaling that the previous upward trend is likely coming to an end. Traders often use this confirmation as a trigger to enter short positions or to take profits on existing long positions.
It's important to note that false breakouts can occur, so it's advisable to wait for a convincing breakout before making trading decisions. Additionally, you should use other technical indicators and tools to confirm the trend reversal and avoid any false signals.
One essential aspect of interpreting this pattern is analyzing trading volume, as it reflects the level of interest and activity in the market.
A decrease in volume from the left shoulder to the head and an increase from the head to the right shoulder can reinforce the pattern's validity. This indicates that the trend momentum is fading and that buyers or sellers are losing confidence.
Additionally, you want to see a surge in volume when the price breaks below or above the neckline, which is the horizontal line that connects the two highs to confirm the bullish reversal. A high volume on the breakout shows that there’s a strong conviction behind the move, with a significant number of active traders.
The Head and Shoulders pattern also provides a potential price target for the subsequent bearish move. This pattern provides a way to estimate the potential price movement following the breakdown of the neckline. Traders commonly use the height of the pattern to determine the potential decline in price.
To measure the price target, start by measuring the vertical distance between the head (the highest peak) and the neckline. Then, apply this distance downwards from the neckline breakout point to estimate the potential decline. This projected decline can act as a target for profit-taking or as a level for setting stop-loss orders.
Keep in mind that the neckline, trading volume, and price target are just estimates and should be used as guidelines rather than absolute predictions. Other factors, like market conditions, and overall trend, should also be considered when making trading decisions.
How to Interpret the Inverted Head and Shoulders Pattern
The Inverted Head and Shoulders pattern has the same three peaks, except the middle one is the lowest (as opposed to being the highest in the case of the Head and Shoulders pattern formation), resembling a W letter on a chart.
Here’s what to consider when interpreting this human head and shoulders turned upside down:
One crucial aspect of interpreting the inverted head and shoulders pattern is understanding the significance of the neckline. The neckline is a trendline that connects the peaks after the formation of each shoulder and the head. It serves as a crucial level of support-turned-resistance.
When the price breaks above the neckline, it confirms the pattern and signals a potential bullish reversal. Traders often enter positions at this breakout point, anticipating further upward momentum. The distance from the neckline to the head can also provide an estimate of the potential price target.
In the case of the inverted head and shoulders pattern, traders should look for three characteristics of volume:
- decreasing volume during the formation of the left shoulder, the head, and the right shoulder; this shows that the sellers are losing momentum and the buyers are gradually taking over;
- increasing volume during the breakout above the neckline; this shows that the buyers have gained control and are pushing the price higher with force;
- sustained or rising volume during the subsequent uptrend; this shows that the buyers are still dominant and there’s enough demand to support the higher prices.
Price targets and stop levels
Determining realistic price targets and setting appropriate stop levels are also essential aspects. Price targets can be estimated by measuring the vertical distance from the neckline to the head and adding it to the breakout point.
Additionally, traders should set stop levels to protect against potential downside risks. Stop loss orders are commonly placed below the right shoulder to limit losses in case the pattern fails to materialize as expected.
*Additional tip: look for additional confirmation from technical analysis indicators, like moving averages, the relative strength index (RSI), and the moving average convergence divergence (MACD).
By grasping the importance of neckline placement, understanding how to set price targets and stop levels, and seeking confirmation through technical analysis indicators, you can effectively interpret both the Head and Shoulders and Inverted Head and Shoulders patterns. This knowledge will empower you to make well-informed decisions and capitalize on potential bullish or bearish reversals.