A Trader Using a Trading Platform. Image source: Simple FX, flickr.com
The head and shoulders pattern is among the most widely recognised chart formations, making it one of the most prominent reversal structures in trading. But despite its easily discernible form, many traders still do not understand the fundamental principles and the inherent logic behind the pattern, which is why we want to dig deeper and explain how to trade the head and shoulders pattern properly.
The psychology behind it?
Just like with every other trend continuation and trend reversal pattern, the most intriguing question for traders is whether the head and shoulders works because of traders reacting to it, or its prominence is already established a priori before traders recognise the pattern's emergence on the chart. Essentially, this is a version of the "which came first, the chicken or the egg" conundrum, but in trading.
The implications of the answer, if a definitive answer can be derived at all, can be profound. If it is possible to demonstrate that the former case is true, the risk of succumbing to various cognitive biases would be increased.
That is so because traders may then mistakenly trade on what they perceive as a head and shoulders pattern, while the broader market takes the opposite view. The inescapable outcome of trying to beat the market should not be too surprising to anyone. Because of those reasons, traders should be acutely aware of what the pattern in question actually represents.
What does the head and shoulders pattern signify?
The pattern is found towards the end of an existing uptrend and signals a likely upcoming reversal with a varying degree of certainty. It is comprised of three successive peaks, the middle one of which being taller than the two around it. The structure also has a baseline (neckline). A breakdown below it indicates the completion of the reversal and the beginning of a new trend.
General Electric 1W Price Chart. Image source: Trendsharks ©, created with TradingView.com
As illustrated on the chart above, the completion of the left shoulder indicates the latest (at that time) attempt of bulls at pushing the price action higher. The subsequent dropdown represents the first indication of waning bullish momentum. Its dip underpins the swing low, which would eventually turn into the neckline of the pattern.
Afterwards, bulls, eager to join the existing trend at a discount, buy the dip in an attempt to drive the price action higher still. This leads to the creation of the head, which is above the shoulder.
A second major reversal takes place then, though still not decisive, which drives the price action temporarily below the neckline. The snap rebound that ensues afterwards, taking the shape of a hammer candlestick, implies that this was a false breakdown. This second downswing entails growing bearish commitment complemented by a corresponding loss of faith in the existing uptrend.
At this point, bears start recognising the gradual transformation of what would eventually become the head and shoulders pattern, and so they start acting accordingly. They place selling orders around the peak of the left shoulder, which triggers the selloff that creates the right shoulder.
Once recognised on the chart, how to trade the head and shoulders?
Unless you are one of those more aggressive bears who try to get ahead of the curve by selling around the peak of the right shoulder, there are several alternative solutions to joining the newly emerging downtrend.
The first entails selling just below the neckline, ensuring that the pattern would indeed be fully completed. Even though this more distinctly risk-averse approach to trading the H&S generates smaller profits at the end, it also has the benefit of protected bears against unexpected market turns.
Latecomers should not feel left out either. With enough patience, they can wait for the decisive breakdown below the neckline to be followed by a potential throwback to this major support-turned-resistance. If they see evidence that the price action consolidates around the previous neckline but is unable to break higher, they can sell the underlying in anticipation of continued price depreciation.
How low can the underlying go?
Once the reversal is completed, and the new downtrend starts to develop, traders would likely want to know for how long they can ride this bearish trend. Though there is no rigid formula that can accurately predict the size of the new downtrend ahead of time, there are certain steps you can take in order to estimate roughly the potential dip of the ensuing dropdown.
Remember that prominent chart formations such as H&S and 1-5 impulse wave patterns are usually typified by the fractal nature of the price action coupled with its scalability. This implies two things. First, broader chart formations, such as trends and corrections, are comprised of lesser distinct patterns on charts with smaller timeframes.
And second, because of this, successive price patterns tend to be proportionate to the ones preceding them. Hence, the significance of the Fibonacci numbers in trading as well.
As regards the H&S pattern, traders can follow one general rule of thumb when projecting the likely size of the new downtrend, though they should keep in mind that this rule is not 100 per cent accurate all of the time. They can measure the length of the distance between the tip of the head and the neckline and plot it below the latter in order to estimate the likely dip of the new downtrend.
Going back to the example above, the distance between the head and the neckline is roughly 145 dollars, whereas the subsequent dropdown bottomed out 151 dollars below the neckline.
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