Trading the currency markets is the result of the personal analysis. That can either be fundamental or technical. When a trader analyzes an economy and buys or sells a currency pair as a result, that’s fundamental analysis. Technical analysis deals with chart patterns.
Technical analysis evolved in time. It changed and it will still change. At first, traders noticed that the price makes repetitive patterns. As such, technical terms appeared. Some patterns survived the test of time. Not all of them, but the most relevant ones.
Nowadays, trading is done automatically. Statistics say that over eighty percent of trades are automatically executed. That’s something that changes the way the patterns look. Before the personal computer and the Internet, technical analysis was done in pen and paper. Today, a computer does most of the job. However, patterns that existed well before the personal computer, are still capable of generating great trades.
Such patterns form the classic technical analysis approach. The head and shoulders pattern is one of them.
Defining the Head and Shoulders Pattern
Above all, a head and shoulders pattern is a reversal one. As such, it appears at the end of trends.
Like with any pattern, the bigger the time frame, the stronger the implications are. Being a reversal pattern, it appeals very much to traders. Everyone wants to pick a top or a bottom. Reversal patterns show exactly that: a possible top or a bottom.
The head and shoulders definition comes from its shape. As such, it has three parts:
- A head. The head is a strong move, followed by a similar retrace.
- Two shoulders.
A head and shoulders pattern consumes the most time with the two shoulders. These are ranging areas and price spends the most time consolidating.
The chart above shows a head and shoulders pattern that forms after a bullish trend. A small consolidation on the left side gives the left shoulder. Next, the price spikes higher. But, it proves to be just a fake move. It comes back to the same area. The consolidation that follows is the right shoulder. Typically, traders look for similarities between the two patterns.
Such similarities offer an educated guess about what the price will do on the right shoulder. Things like the amplitude and the time taken for the price to consolidate on the left shoulder are used on the right one. Before moving forward, it is important to understand that the pattern changed in time. Because of fast execution, these days the head and shoulders pattern doesn’t look like it was a few decades ago. As such, it is not uncommon for the Forex market to form ugly head and shoulders patterns. They don’t form only on horizontal necklines.
How to Trade the Head and Shoulders Pattern
The key here comes from the other two elements part of the pattern: the neckline and the measured move.
A neckline is a line drawn below the consolidation areas. Or, below the two shoulders. The idea is to trade a break of it. When the neckline is broken, traders go for the target. The measured move gives the target. Traders calculate it by measuring the distance from the neckline to the highest point in the head and shoulders pattern. More exactly, from the neckline until the highest value in the head. That’s the measured move. Next, they project it from the neckline. The downside target represents the take profit.
The chart above shows the previous head and shoulders pattern. Only this time, it has the neckline and the measured move as well. The neckline, or the blue line from above, shows clearly the consolidation areas on the left and right side of the chart. Or, the two shoulders.
While it is not a rule of thumb, most of the times the neckline gets to be retested after the break. In this case, it so happens that the price retested it. That’s the perfect place to go short. As for the take profit, here’s where the measured move comes into discussion.
As mentioned earlier, the measured move is the distance from the top of the head until the neckline. Projecting it below the neckline, it gives the take profit or the target. However, there’s a trick. Where should the stop loss be? If you place the stop loss at the maximum value given by the head and exit when the measured move is reached, that’s not a proper risk-reward ratio. As a reminder, a risk-reward ratio shows the gain expected compared with the risk taken. Typically, the bigger the ratio, the better. But, even the Forex market spends most of the time in consolidation. As such, traders must use realistic ratios.
However, in the example above, at best, the risk-reward ratio is 1:1. That’s not enough. Trading is a game of probabilities. While traders know that losses must be embraced, they need a bigger winning percentage. Yet, the head and shoulders pattern is powerful. Above all, it shows reversal conditions. As such, traders can use an appropriate risk-reward ratio. Values like 1:2 or 1:2.5 are normal ones. In this case, the take profit comes quite fast.
Conclusion
To sum up, the head and shoulders pattern is a powerful reversal pattern. While it has many component parts, each of them plays an important role for the future price action. It is one of the oldest patterns in technical analysis. Virtually, there’s no trader that didn’t hear about it. But, trading changed. Technological changes made trades to be automatically executed.
Moreover, trading algorithms are programmed to spot patterns like a head and shoulders. And, to over-run them. Or, to trip the stops. Therefore, it is important to have a stop loss in place. And, a take profit part of a sound money management system. Still, classic technical analysis patterns work in various time frames. As a rule of thumb, the bigger the time frame, the bigger the chances are that the noise will be filtered and the pattern will run its course.
