Head and Shoulders
A head and shoulders pattern is also a trend reversal formation.
It is formed by a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder). A “neckline” is drawn by connecting the lowest points of the two troughs. The slope of this line can either be up or down. Typically, when the slope is down, it produces a more reliable signal.
The head is the second peak and is the highest point in the pattern. The two shoulders also form peaks but do not exceed the height of the head.
With this formation, we put an entry order below the neckline.
We can also calculate a target by measuring the high point of the head to the neckline. This distance is approximately how far the price will move after it breaks the neckline.
We know you’re thinking to yourself, “the price kept moving even after it reached the target.”
And our response is, “DON”T BE GREEDY!”
Inverse Head and Shoulders
The name speaks for itself. It is basically a head and shoulders formation, except this time it’s upside down.
A valley is formed (shoulder), followed by an even lower valley (head), and then another higher valley (shoulder). These formations occur after extended downward movements.
Our target is calculated just like the head and shoulders pattern. Measure the distance between the head and the neckline, and that is approximately the distance that the price will move after it breaks the neckline.
If your target is hit, then be happy with your profits. However, there are trade management techniques where you can lock in some of your profits and still keep your trade open in case the price continues to move your way.
You will learn about those later on in the course.