The head and shoulders is a highly reliable and widely-followed trend reversal chart pattern. There are two variants of this formation. The head and shoulders top is commonly viewed as a bearish reversal pattern that is formed after prices on the cryptocurrency chart have witnessed a sharp rise and are preparing for a move lower. By comparison the head and shoulders bottom signals that cryptocurrency prices are set to potentially gain after a protracted period of downward trending prices.
Both of these head and shoulders variations have identical chart features in that a price peak or trough (head) is surrounded by two lower peaks or troughs (shoulders), with a bottom that is connected by a “neckline.” The pattern is confirmed when the neckline gets breached post the completion of the second shoulder.
The Head and Shoulders Top
The head and shoulders top pattern emerges after a steep rise in cryptocurrency prices, and the completion of this formation represents a reversal in the market’s trend from upward to downward. The pattern is made up of three successive price peaks, with the middle peak, referred to as the “head,” being the highest.
The head is flanked on either side by two relatively lower price peaks – the left shoulder and the right shoulder. The swing lows are then connected to form a “neckline,” which acts as an area of support, and whose capitulation signals the trend has reversed.
During the course of an uptrend, cryptocurrency prices rally to new highs to create the left shoulder. From there, a retracement ensues to plot a reaction low. The selling pressure soon eases, and the subsequent rebound takes cryptocurrency prices to a fresh swing high that forms the head of the pattern. The bulls make one last attempt to lift prices above the head, the failure to do which, results in the formation of the right shoulder.
The neckline connects the reaction lows that appeared after each price peak. Necklines that are downward sloping deliver the highest likelihood of the pattern yielding a positive return.
The pattern is confirmed once the neckline support is decisively broken to the down-side on greater than average volume. After the resistance is breached, traders can expect one final price bounce to the neckline. This offers an ideal entry zone for those who missed out on the original break-down.
The price target for head and shoulders top is calculated by measuring the distance from the peak that forms the head of the pattern to the neckline. This distance is then plotted below the neckline to arrive at a target cryptocurrency price.
Cryptocurrency Chart Example
The Head and Shoulders Bottom
A head and shoulders bottom forms after an extended bear run, and its completion signals a reversal in trend. The pattern consists of three consecutive cryptocurrency price troughs, with the middle trough, called the “head,” surrounded by two relatively higher troughs (shoulders). The swing highs following each trough are connected to form the “neckline.”
For the formation of a head and shoulders bottom, it is important to establish the existence of a prior downward trend on the cryptocurrency chart. Without a prior trend in place to reverse from, there can be no pattern. During a down trend, cryptocurrency prices first decline to form a new low. After plotting this trough, prices bounce-back to complete the left shoulder.
From the peak of the left shoulder, cryptocurrency prices again drop to below the low of the left shoulder. This marks the head of the pattern. The subsequent rise takes prices to the resistance zone that is holding the down trend intact. The right shoulder is one final attempt by the bears to maintain the selling momentum, the failure to do which, results in a change in trend from down to up.
While symmetry in the pattern is welcome, it is not a necessary pre-requisite. The two shoulders can and will often be of different heights. Similarly, the neckline connecting the reaction highs on the cryptocurrency chart may also not be absolutely horizontal. It can either slope down or up. Traders however need to note that the slope of the neckline can affect the degree of the pattern’s bullishness, with an upward slope more likely to result in a bullish reversal.
Volume plays a critical role in the unfolding of the head and shoulders bottom pattern. Generally, market participation during the formation of the left shoulder would be higher than during the dip to form the head. This contraction in volume should serve as a warning of the imminent reversal in trend.
The pattern is complete and the downward trend is reversed when the neckline gets convincingly broken to the upside. This should ideally be accompanied by a substantial jump in volume. The target for the move higher is equal to the distance from the neckline resistance to the bottom of the head.
Cryptocurrency Chart Example
The Final Word
The head and shoulders is an easy-to-spot pattern. Once a cryptocurrency trader knows what to look for, the pattern will appear on all times frames, be it for intraday trading, swing trading or long-term investing. The formation also provides precise entry levels, stop-loss marks and take-profit targets, simplifying the entire trade and risk management process.