Price movements in the market are common and you will need technical analysis to guide you if you want to be able to anticipate how a trend will likely look like in the future. This is where chart patterns come in, and one effective way to predict market directions is by using the Head and Shoulders Pattern. While the Head and Shoulders pattern is a high-probability pattern, some traders still find its construction quite complicated. This piece can help you determine if a trading strategy based on this pattern is suitable for you.
What is the Head and Shoulders pattern?
This pattern is a chart or trend reversal pattern that usually shows in uptrends. It can be a top or bottom pattern since an inverse Head and Shoulders pattern is also possible. It typically has four parts: the left shoulder, the head, the right shoulder, and the neckline.
Imagine a chart of price actions in the market. The Head and Shoulders bottom will be a series of either rounded or sharp peaks, particularly three well-defined ones. In this structure, you will see that the second peak, or the Head, rises the highest than the first or third peak. The Head section is the central peak of the pattern. The first peak is the Left Shoulder, while the third peak is the Right Shoulder. Both Left and Right Shoulders are always positioned beneath the Head but do not necessarily align at similar heights. The Neckline is simply a line drawn that connects the troughs’ lowest point.
A Neckline’s slope is either up or down, but a more reliable signal is associated with a downward slope.
What causes a Head and Shoulders pattern?
When you see a Head and Shoulders pattern, it may mean that buyers are slowing down, and a potential reversal is coming. The price structure is not usually the cause of the market reversal, but the transition happening between buyers and sellers is. For example, with the Head, pulling back trends may occur and, and with that, buyers are unable to push back the price higher than the Head. This leads to the formation of the Right Shoulder. It is worth mentioning that the sequence of chart highs and lows can shift, and this shift may give us a warning of an upcoming trend change.
What to look for before trading?
It is important for traders to recognize market trends. Therefore, charting price movements becomes imperative. And the market’s structure depends on trend cycles and their duration. While the pattern is related to chart or trend reversals, a strong uptrend in the market could mean that a simple chart pattern will unlikely reverse. You will probably see the market go higher.
Pattern duration is another thing – between a 200-day Head and Shoulders pattern and one that takes 30 days to form, the longer-period pattern is more significant. In case the market breaks the given 200-day Neckline, you will see more traders getting trapped. Their rush for exit can lead to an increase in selling pressure. Hence, finding a reliable Head and Shoulders Pattern involves market structure and pattern duration considerations.
After establishing the market trend, it is important to pinpoint the Left Shoulder, and this will require patience. Given a potential left shoulder, we will then look for the Head section. The Neckline will then confirm the upward or downward movement of the market.
Trading using the Head and Shoulders pattern
The Neckline is very important if you are using this formation in your trading strategy because it draws your breakout level. Others often anticipate when the Neckline breaks, but this technique exposes you to far greater risk and you may end up getting disappointed. Volume is another factor to look out for, as it rises higher on the left shoulder. Thereafter, you will see decreasing volumes throughout the formation. The most crucial point for volume is at the Right Shoulder, as an expansion makes a breakout valid.
There are two ways to trade using this pattern:
- Buy or sell the breakout candle going through the Neckline; or
- Wait for the Neckline to have a correction.
You normally measure the profit target using the distance you get between the Neckline and the Head, projected from the breakout price. You can place conservative stop-loss orders just above the Right Shoulder even if the risk or reward calculation offers no more than a 1:1 ratio. This means you’ll need to win above 50% of your trading time to profit.
Stop-loss placement may vary from one trader to another, and additional technical tools may help. For example, you may opt to trade under this pattern if it aligns with resistance or support level, or if it forms alongside the market’s moving average crossover.
Try the strategy now
Trading using the Head and Shoulders pattern is one of the few consistent strategies employed by traders in the forex market. While there can be no absolute guarantees, this formation can help you become a profitable trader. Ask your broker now for more information about the Head and Shoulders Pattern.