For the technical trader, there are a handful of trading patterns that they tend to turn to time and time again. Without a doubt, one of the most common patterns is the “head and shoulders pattern.” In fact, there are some traders out there that will trade only this pattern, but there are a couple of things to keep in mind before you use this pattern, just as anything else.
The first thought that comes to mind is that nothing is 100% guaranteed. However, some of the more obvious patterns, such as the head and shoulders pattern, will attract more flow as everybody else sees the same thing. Think of it this way: if everybody in the market sees a potential buying or selling opportunity, it makes sense that a lot of traders will follow it.
Defining the pattern
The first thing that we need to do is to find what the pattern is. The head and shoulders pattern features three parts, the left shoulder, the head, and the right shoulder. It is a pattern where you get a high that forms, a pullback, a higher high, and then a low or high. In other words, the third part of the pattern, the right shoulder, is a lower high from the head.
Take a look at the GBP/CHF four hour chart just below. It is an example of what a head and shoulders look like. The high labeled “1”, is what is called the left shoulder. The second peak that is labeled “2” is the head. And then finally the third peak labeled “3” is what is known as the right shoulder. What this represents is an uptrend that is running out of momentum.I would also point out the red line underneath the three humps that make up the pattern. This is known as the “neck line” and is the trigger to start selling. Once we break down below that level, everybody in the previous three waves higher are now underwater and will have to sell their positions to exit the market. That presents an opportunity as it pushes even more downward pressure into the marketplace.
Notice that the blue line extends lower from the neck line, and down to an area that was eventually hit. That is the target. How does the pattern suggest a target? It is simply a measurement from the top of the head down to the neck line. In other words, if the head and shoulders pattern is 300 pips tall, on a break below the neck line, we should see a move a 300 pips from that point. In this example, you can see that we broke down rather significantly, bounce back up into the pattern, and then eventually hit our target. As a side note, many traders will use the right hand shoulder as a place to put their stop above.
Not all head and shoulders patterns need to be negative
As is the case with many technical patterns, there is an inverse pattern. This is simply a series of three lows, starting with the left hand shoulder being a bounce back to the upside, followed by a break down to form the head, a bounce back to the upside, and then a “higher low” forming the third shoulder. Simply put, it is an “upside down head and shoulders pattern.” This means that the sellers are running out of momentum, and the market could very well rally significantly. Look at the following chart and see how this works in an inverse pattern. You should recognize that it is the exact same thing, only turned upside down.
Another tool for your toolbox
The head and shoulders pattern is simply another tool that you can put in your trading toolbox and is used by enough traders out there that it tends to be a bit of a self-fulfilling prophecy. Obviously, nothing works 100% of the time but one thing that can help you is to focus on higher time frame head and shoulders patterns, because they take much more volume and trade action to form. In other words, many more people will be out there paying attention to them because they take so much more effort to form.
Remember, simplicity is one of the hallmarks of a good trading system, if of course you need other people to move right along.
These obvious patterns are quite helpful, because you can have the rest of the market pushing in the same direction.