Head and Shoulders Strategy
Last Update: July 15th, 2019
We have already discussed ‘Candlestick Trading Strategy’ which allows us to understand the candlestick charts and what each candlestick indicates. However, to really become a master of the charts, we must learn about a few common chart patterns and what information we can draw from them about the future.
The ‘head and shoulders’ pattern is one of many recognizable and tradable chart patterns. In forex jargon, they are known as “shampoo” because of the shampoo brand of the same name. Head and shoulders forex patterns consist of a high peak in the middle and two double peaks on either side of that one as can be seen in the illustration below. The higher peak is the head and the two lower ones are the shoulders. The pattern itself looks like a head between two shoulders, hence the name.
Head And Shoulders Trading
Head and shoulders patterns become relevant when the neckline is penetrated. Once the neckline is broken, we may look to open a short position on the opposite side of the head and shoulders trading indicator.
Some traders enter immediately, while others prefer to enter on a pullback and retest of the neckline. The latter option is safer because now we know that this is not just a fake-out. The number of pips targeted in this strategy is approximately the same as the number of pips between the top of the head and the neckline. When the market is feeling right, and there is more room to go after reaching the target, we might aim for bigger profits and let the trade run.
Head And Shoulders Trading Pattern Consist Of One High Peak (Head) And Two Lower Peaks (The Shoulders).
Head And Shoulders Forex Pattern On A Typical Candlestick Chart.
The pictures above are very clear and allow for very clear recognition of the head and shoulders trading pattern. Don’t expect the real charts to be as clean — they will provide more of a challenge. To trade these patterns we have to spot them in real-time as they happen, not after they are irrelevant.
The bottom line, commonly referred to as the neckline, is actually a support level. It may not always be a straight line, but an ascending or descending line. The slope component to the neckline makes it much more difficult to spot, thus we must focus on the bigger picture. Junior traders should probably switch to a line chart which makes some patterns more visible, instead of the candle chart. The picture below is a real chart showing a head and shoulders forex pattern. Recognizing the head and shoulders trading pattern in real-time and trading it successfully is much more difficult than shown here in the illustrations.
Spotting Head And Shoulders Forex Patterns
As mentioned above, the neckline must be broken in order for the head and shoulders pattern to be usable. Nonetheless, real-life trading doesn’t follow textbook rules so strictly. We have to be flexible and clever to spot these patterns as they are forming, in order to minimize the risk and maximize the profits.
One trick for early pattern recognition and entering high probability winning trades is to look at the volumes. No matter the time frame, volume is supposed to decrease with each peak. Of course, as with most things trading, this isn’t always the case. The lower volume on the second peak, which is the head, means that buyers had a try on the upside, but without much force. As a result, price eventually goes down.
When we are at the top of the second shoulder and volume is low, we should check other indicators such as RSI and Stochastics to see if the pair is overbought. If that’s the case, and if pins, dojis or inverted hammers are forming on the candlestick chart, then we might enter the trade with a stop above the head. This way we almost double the profit target and increase the risk-reward ratio. The chart below illustrates the use of this head and shoulders trading strategy on an ascending pattern.
Volume Decreases With Every Peak.
Inverse Head And Shoulders
‘Inverse Head and Shoulders’ patterns are the opposite of head and shoulders. All rules apply, but they are simply upside-down. In this case, the neckline also serves as resistance. This means we must look to buy upon the break of the neckline. Like head and shoulders, they may be straight, ascending or descending.
Inverse Head And Shoulders Trading Is Exactly The Same But Upside-Down.
Head and shoulders patterns are not a forex trading strategy on their own. However, they do help us to get a better picture of what is going on and what is going to happen next. Being able to spot these patterns can be the difference between a winning trade and a losing one.
As you gain more experience as a trader, try incorporating as many of these techniques into your trading technique basket as possible. Likely results are enhanced performance and an opportunity to make more money.