Head and Shoulders Pattern
The head and shoulders pattern is a popular chart pattern that suggests the possibility of a trend reversal in the cryptocurrency market. It gets its name from its similarity to a person's head and shoulders. This pattern usually appears at the end of an upswing and indicates a change in sentiment from bullish to bearish.
Components of head and shoulders pattern
Left shoulder
The left shoulder is the first peak to form during an uptrend. It signifies a temporary high point in price where buyers start losing momentum, thereby resulting in a minor correction.
Head
The pattern's tallest peak, the head, usually forms after the left shoulder. It symbolizes a strong resistance level where buying pressure reduces and sellers take control. The head is higher than the left and right shoulders, forming a noticeable peak.
Right shoulder
The right shoulder develops after the head and is lower than the head and left shoulder. It marks yet another failed attempt by buyers to increase the price. The right shoulder is similar to the left shoulder but less pronounced than the head.
Recognition and confirmation of head and shoulders pattern
Identifying the head and shoulders pattern requires close attention to price and volume movements. To confirm the pattern, traders often look for the following features:
Symmetry
The left and right shoulders should be roughly the same height and form. The head should be higher and have the most prominent peak.
Neckline
The neckline joins the lows of the left and right shoulders. It serves as a support level that, when broken, validates the pattern. Depending on the trend, the neckline might be horizontal, ascending, or descending.
Volume
Volume should drop from the left shoulder to the head and then increase again as the right shoulder forms. Additional confirmation is obtained from a significant increase in volume during the breakdown of the neckline.
Potential trading strategies based on head and shoulders pattern
Both conservative and aggressive traders can profit from the head and shoulders pattern.
Conservative strategy
Conservative traders wait for a confirmed breakdown of the neckline before entering a trade. They initiate a short position when the neckline is breached, with a target price set below the expected distance from the neckline to the head. To manage potential risks, a stop-loss order is set above the right shoulder.
Aggressive approach
Aggressive traders who anticipate the completion of the pattern may enter a short position before the neckline breakdown. This method, however, has greater risks because the pattern may not always be followed. For confirmation, aggressive traders should actively observe price action and volume.