Learning to identify and trade different patterns is important in becoming a successful trader. However, there are a few patterns that are more crucial than others to understand. Understanding and trading the head and shoulders pattern, a sign of trend reversal, can help to increase profits while minimizing losses.
Identifying a Head and Shoulders Pattern?
A head and shoulders pattern has a distinctive shape. It can be identified by three peaks in a row with the middle one the highest. These peaks are separated by deep valleys. The tallest peak is the ‘head’ and the two surrounding peaks are the ‘shoulders’. There will be noise and mild fluctuations between the peaks and troughs, so look at the big picture.
The most important thing to understand about the head and shoulders pattern is that it is a sign of rapid reversal in a market’s price. Experienced traders can predict how far the value will fall with a simple calculation. Draw a line from the bottom of one valley to the other. This is referred to as a neckline. Then, draw a vertical line from the neckline to the top of the highest peak, or head. This line represents roughly how far the price will drop once it has crossed the neckline and completed the second shoulder.
The Inverse Head and Shoulders
The inverse head and shoulders pattern is the classical upright pattern, flipped upside down on a horizontal axes. You will see three deep troughs in a row, with the middle one the deepest. As with the traditional head and shoulders pattern, you can predict growth by drawing a neckline between the two shoulders and measuring the distance from this neckline to the deepest valley. Once the price rises above the neckline, it will likely increase an amount that is roughly equal to the distance from the neckline to the deepest trough.
In general, the head and shoulders pattern is considered more reliable when it is in an inverse pattern like this. This pattern marks the end of a downtrend and signals that the asset is about to enter a steep upward trend.
How to Trade When You See a Head and Shoulders Pattern
Once you learn to recognize this pattern, you will be able to predict when a stock is about to quickly change trend. The head and shoulders pattern represents ambivalence in the market as the new trend gains traction and momentum. You should calculate the distance from the neckline to the crown of the head and make this your target, setting stops just beyond this point.
When should you make your move? Convention wisdom holds that you should wait until the price has hit the neckline of the second shoulder before taking action. It is fine to act before this, but it is more of a risk. More conservative traders will simply calculate the neckline and the projected change, then wait until the exact right moment. However, this means that you may miss a few opportunities. As always, your trading style will influence how you treat this pattern.
The most common mistake that many new traders make when trading this pattern in Forex is getting greedy. If the asset hits its target and surpasses it, they are tempted to try to earn even more. However, there is significant evidence that assets following this pattern will not be as predictable beyond their target. This is the time to lock in your profits, even if you decide to continue trading this asset. Many platforms, such as AlfaTrade, allow you to lock in profits before continuing to trade an asset.
Another mistake is not knowing your market. Unexpected events can change or halt this pattern. General understanding of external events in the political and business world can help you to avoid jumping in on a head and shoulders pattern that is about to be interrupted by market forces.
What Causes a Head and Shoulders Pattern?
This pattern is seen when an asset is about to make a rapid and steep shift. There are three distinctive peaks as investors buy while other investors sell. Once the new pattern has gained momentum, it will quickly shoot off in the opposite direction. The distance between the neckline and the top of the head is significant because this shows how far the market can viably move in the new future. Some assets are more volatile than others and thus will have wider fluctuations.
While no market pattern is guaranteed to follow the predicted course, this common pattern is more predictable than most. Head and shoulders is an easily recognizable pattern that can be easily visualized and acted upon. This pattern is a favorite of both new and experienced traders due to its high profit potential.