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Sunday, June 12, 2011

Head and shoulders pattern


Head and shoulders is the topic of the post. Those who have any understanding about technical analysis definitely know what it is. Let me talk a little bit on the theme. I will give you a chart first and some theoretical and practical points later. 

Head and shoulders definition

As you may see head and shoulders pattern is a reversal pattern that usually happens after a prolonged uptrend or a swing. It consists of three highs: left shoulder, head and right shoulder. The structure is joined by a neckline that constitutes support

How is head and shoulders pattern formed?

This works best on longer term charts. Firstly, there should be an uptrend in place for the pattern to be as effective as possible. After a prolonged uptrend prices may start going kind of parabolic and suddenly collapse. This helps to form the left shoulder and the point for a neckline. Then uptrend resumes and prices go beyond previous highs (left shoulder). Then security collapses again and lands somewhere near previous support. Security rallies for the last time and finds resistance lower than the head is and collapses again. This time, it goes beyond support and a downtrend begins. If the security is not able to break the neckline, the pattern is usually distorted and the security either starts going sideways or resumes its’ upward trend. 

How to trade head and shoulders pattern on daily and weekly charts

On daily charts the pattern can be very big, stretching from three months to one year or sometimes even more. So, one has to be pretty patient waiting to see possible place of entry. In fact it is much better to spot those patterns on weekly charts (if we have in mind reversal that happens after a very long uptrend is finished). 

To tell the truth one can never be sure if one is looking at a real head and shoulders pattern or simply a pattern which looks like the real one. Difference between real one and a fake one is not very big. The real one is fulfilled, the false one is not. The real one is fulfilled when the price after having formed the right shoulder collapses through the neckline. That the only way to know whether the pattern is the true one or a false one. You have to wait for a collapse through the neckline. So, the best way to trade it is to place a sell stop order below the neckline and go short when the prices go beyond the level. 



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False breakouts in head and shoulders pattern

It might be a false break too and the prices can come back and go above the neckline. However, you have no other choice, either you risk and jump on the trade or you stand aside and continue waiting. In the latter situation you will be sure that it was the true head and shoulders pattern after the move down have gone so far that it is no longer useful for you to join it. So, you go short after the neckline is broken.

Head and shoulders after a swing

These kind of patterns happen all over the charts and on various time frames. They are pretty reliable when they happen in a range after a prolonged swing. I find four hour charts most reliable to identify the pattern and trade a reversal of a trend. The rules are the same as in the pattern on daily or weekly charts. You have left shoulder, head, right shoulder and a neckline. You go short below the neckline if it is broken and go with the swing down as long as it has momentum. Very often the break of the neckline may coincide with some economic news as it happened in the above example with eur/usd pair or eur/cad pair last Thursday. News from Europe pushed those two pairs below their necklines and we had a nice move down (which is not over yet). 

That’s how you trade head and shoulders pattern. I hope to expand the post in the future adding more information and examples of the pattern.




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Disclaimer
Trading financial markets carries a high level of risk, and may not be suitable for all investors. All information on the blog is of educational nature and cannot be considered as advice, recommendation or signals to trade in any financial markets.