Forex Factory: Technical Chart Analysis - The Head and Shoulders Pattern (Part 1)
Telling you the truth, learning about trading technical analysis isn't going to be easy. Among these technical market chart analysis is the head and shoulders pattern. In this post, you are to learn what head and shoulders pattern is and how to analyze this within the market.
With this, you'll be able to know whether to buy or sell within the market and where will be the most appropriate entries or exits. Now let us start the lesson by knowing each part of the head and shoulders pattern.
(All sample charts present in this post are based on real market scenarios)
Head and shoulders pattern parts:
In order to understand each part, you can visualize each in the sample chart below. You'll further understand the technicalities in the next paragraphs.
The "Left Shoulder" is the point wherein the market does a pullback. At this moment, there are no exact indications if the market reverse as pullback often occurs within a trending market.
The "Head" indicates that the market is trading above the previous peak/high. But at this point, the sellers are in control pushing the price lower going to the previous low, in which somehow forms the neckline of the pattern.
The "Right Shoulder" is when buyers are on its last attempt in pushing the price higher. However, it fails to break above the previous peak (the head level). After that, the sellers again take control pushing the price to the neckline.
Lastly, the "Neckline" being the last line defense of the buyers. Whenever the price breaks below, the market might head lower to start a downtrend.
The four parts explained then indicates that this pattern can signal a possible trend reversal. Simply saying, the buyers can't push the price higher in the market.
If this pattern then occurs in the opposite way, it is called the Inverse Head and Shoulders pattern. Meaning it can signal a possible trend reversal wherein the sellers aren't able to push the price lower within the market.
Learning the head and shoulders pattern further, you are to learn the two must before doing trade in a head and shoulders chart pattern. There are at least two things to consider in dealing with a head and shoulders market pattern.
The head and shoulders is a reversal chart pattern. However, if the market has a strong uptrend, it would be strange that simple chart pattern reverses in its move. Rather, the market continues to move higher. Look at the sample chart below wherein a small head and shoulders pattern got crushed by a strong uptrend.
If a head and shoulders pattern took 200 days in order to form it has greater significance than those which formed in 20 days. How's that so?
The market breaking the 200-day neckline could trap more traders. In addition, in this scenario, the trapped traders are likely to rush their exits resulting in increased selling pressure.
Trading Head and Shoulders Breakout with a Buildup:
Moving on, oftentimes there are head and shoulders pattern going short on the break of a neckline. Where would it be best to put a stop loss? The best advice is above the head of the pattern. Observe the sample chart below to understand why.
Obviously, the stop loss is bigger which may result in poor reward risk. The market should move Now, is there any other way to trade in a head and shoulders breakout? Actually, there is, it's trading breakout with a buildup. Meaning a wise trader will wait for the market informing tight consolidation close to the neckline/support.
Whenever the market breaks down, a trader can reference stop loss above highs of a buildup. With that, a trader will have more favorable reward risk compared to a set stop loss above the high of the head. Observe the sample chart below to understand further.
Catching Initial Pullback Upon Breakdown
Some might wonder, what if the market does not form buildup, instead it continues to move lower. There are three points to consider in understanding how it works. One, if the market breaks down without a buildup, a trader should wait for an occurrence of a pullback. Two, whenever the market had its pullback, go short within the break of the swing lows. Lastly, set a stop loss over the highs on the pullback.
Observe the sample chart below wherein the initial pullback occurs upon a breakdown.
That ends our first part of the discussion on how to analyze a head and shoulder pattern. We'll continue our discussion on how to analyze a head and shoulders chart pattern in the market chart.
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