Head and Shoulder Patterns

Recognising certain charting patterns as they are forming can be exhilarating and leave you holding your breathe as you anticipate the completion of the pattern. No pattern in forex charts could be simpler to spot than the Head and Shoulder one which predicts a trend reversal from a bullish to a bearish scenario. Believed to be one of the most reliable trend reversal patterns, a Head and Shoulder pattern signals, with varying levels of accuracy, that an upward trend is going to end soon. Indicators like this one are widely used in forex trading as they provide definite signals about a change in or continuation of a trend. Thorough understanding of these indicators and the timely identification of trading opportunities can prove to be quite fruitful for forex traders.

What is a Head and Shoulder Pattern?

This technical chart is named head and shoulder because it comprises three components, with the first and third looking like the shoulders and the second one standing high between them, just like the human head. The three main components of this pattern include:

  1. After a long and bullish trend, the price of a currency reaches a peak level and starts declining thereafter, to form a trough.
  2. The price starts rising again to form a second high, which is significantly higher than the initial peak, and starts declining thereafter.
  3. The price rises for the third time, but only up to the level of the first peak, before declining once more.

The line connecting the first and second trough is called the neckline of this pattern, and is a key component of a trading strategy based on this pattern. The neckline should be either a horizontal line or an ascending one, but never a descending line, since a descending neckline is an indication of a weak reversal trend. Also, the steeper the angle of the neckline, the more aggressive is the breakout and reversal.

Similarly, an inverted head and shoulder pattern signals that a downtrend is about to reverse and change into an uptrend. In this case, the pattern depicts three consecutive lows that are separated by temporary rallies. In this case, the second and the lowest trough is the head, surrounded by the first and the third declines that indicate the shoulders. The final rally after the third decline indicates that the trend has reversed and prices are likely to keep rising from here.

Using the Head and Shoulder Pattern for Forex Trading

This an easy-to-identify pattern and very popular amongst forex traders. Since this type of pattern can appear on all time frames, it can be used by day and swing traders alike. But one needs to remember that actual formations are generally not perfect, and there can be some noise between the shoulders and the head.

Identification is easy and begins with looking for the two shoulders and one head, followed by the establishment of the neckline. Trading decisions based on half formed patterns are not wise decisions. A trader should wait for the entire pattern to be completed, and not make assumptions prior to this. A head and shoulder pattern should be used for trading decisions once the price moves lower than the neckline, after the peak of the right shoulder, and similarly in the case of an inverse head and shoulder pattern, the price movement above the neckline after the right shoulder is formed. So, an appropriate trading strategy is to wait for a daily close below the neckline before making an entry trade. This will help mitigate the risk of having the market snap back on your position and stop you out for a loss.

Like all trading strategies, the success of this pattern depends on its correct identification and ensuring that the whole pattern is formed, rather than jumping into trades prematurely. The most common entry point for this strategy is at the breakout of the neckline, with a stop placed above the right shoulder. All in all, a head and shoulder pattern provides entry points, stop points and profit targets, making it an ideal tool for implementing a forex trade strategy.

 

Disclaimer

If you liked this educational article please consult our Risk Disclosure Notice before starting to trade. Trading leveraged products involves a high level of risk. You may lose more than your invested capital.

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