The head and shoulders pattern is a chart pattern that fools many traders, however, if traded correctly, it can allow traders to catch the start of a new trend and even "predict" market bottoms in advance.
What is a head and shoulders pattern?
The head and shoulders pattern is a bullish pattern, indicating that it is under the control of the buyer at this time, as follows:
Now let's look at what head and shoulders really mean:
Left Shoulder - This is a pullback to a downtrend due to profit-taking or eager buyers entering the market
Head - Sellers are still in control when they push the price lower, however, at this point buyers step in and push the price higher and test the previous high.
Right Shoulder - Sellers become weak as they are unable to push the price lower, conversely, buyers are getting stronger while continuing to push the price higher, thus retesting the resistance area.
If the price breaks through the resistance level at this time, the head and shoulders bottom pattern is confirmed, and the price may continue to rise.
Common Mistakes When Trading Head and Shoulders Patterns
The duration of the head and shoulders pattern is important. The longer the formation time of the pattern, the greater the possibility of the formation of the pattern, conversely, the shorter the duration of the pattern, the greater the possibility of failure. Especially when a trader is trading based on the current trend. As shown below:
The "small" head and shoulders pattern in a downtrend, we can see that for the past 12 months, the price has been in a downtrend, and then formed a head and shoulders pattern within a few weeks. So at this time, will the 12-month trend prevail, or will the head-and-shoulders of a few weeks prevail?
When to Trade the Head and Shoulders Pattern?
When the following three situations occur, traders need the main head and shoulders pattern (for reference)
1. When the market is in an upward trend
2. When the pattern favors a higher time frame structure
3. When the pattern forms more than 100 K lines
The following are respectively described:
1. When the market is in an upward trend
As you can see, the head and shoulders pattern is a bullish chart pattern, so when the price is in an upward trend, the possibility of profit increases, as shown in the figure below:
2. When the pattern favors a higher time frame structure
On its own, the head and shoulders pattern is not important, however, if it is close to a higher time frame structure (such as support or resistance of a larger period), it can be a powerful chart pattern at this time. As shown below:
You can see that the price is at support on the daily time frame, so let's zoom out a bit:
The head and shoulders pattern on the 2-hour time frame relies on the support structure on the daily chart
3. When the pattern forms more than 100 candlesticks
A "small" head and shoulders pattern can fail in a strong downtrend, so if the market reverses, this chart pattern should form at least 100 bars. Because over time, more buy stop orders will accumulate above the high of the neckline, and if the price breaks out of the neckline, it will push the price higher. As shown below:
The chart pattern in the figure lasted 27 days and 12 hours, forming a total of 103 K lines.
Head and shoulders pattern: breakthrough and accumulation
Not all head and shoulders patterns are created equal, as the way the right shoulder forms is a key factor in whether a trader wants to trade a breakout, for example:
If the right shoulder of the head and shoulders pattern is long, you need to avoid entering the market after the breakout. why? Since the price has moved a long way from the low of the right shoulder to the resistance area, it has attracted a lot of buyers at this time, so the market is likely to face profit-taking (selling pressure from buyers)
So the best way is to use the breakout to trade the breakout. As shown below:
The right shoulder is tight, and when a trader sees multiple pressures on the resistance line, it indicates that the trader has buying pressure that is willing to buy at a higher price, so when the price breaks through the resistance level, a series of stop losses Will provide fuel for price increases. In addition, the stop loss is finally placed below the low point of the right shoulder.
What if you miss a breakout trade?
We can't trade every breakout exactly, so what should we do when we miss a breakout trade?
1. If the price suddenly breaks out, wait for the previous resistance level support to retest
2. If the price retests the area, wait for a bullish signal to appear (e.g. hammer pattern, bullish engulfing pattern, etc.)
3. If there are entry conditions, the stop loss should be 1 ATR lower than the support level
Let's take a look at the following example:
Price retested the area and formed a bullish engulfing pattern
Head and shoulders pattern: the first retracement
The first pullback after a breakout is actually a good trading opportunity, because traders who missed the previous trading opportunity are eager to catch up with the trend for fear of missing out, so when the price breaks out to a new high and forms a new buying When entering pressure, buying pressure may be broken quickly.
1. If you miss the breakthrough, don't rush to catch up with the market. On the contrary, it is better to wait for the price to pull back.
2. Ideally, the callback is small
3. If there is a pullback, go long when the swing high is broken, and the stop loss is 1 ATR below the swing low
As shown below:
How to choose the exit point?
There are two ways to exit a trade:
1. Price forecast
2. Trailing stop loss
1. Price forecast
In the chart analysis, calculate the distance between the head and the neck, and then add it to the breakout point, and the position of the upper high point is the take profit exit point. As shown below:
2. Trailing stop loss
Unlike forecasting, trailing stop loss does not use a fixed target point to take profit, the specific method is as follows:
Determine the type of trend to do (whether it is a short-term, medium-term or long-term trend)
With proper moving average trailing stop loss
Exit the trade when the price closes at the moving average.
As shown below:
Article source: Rayner Teo, an independent trader in Singapore, the most concerned trader, and the founder of the TradingwithRayner website.
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