Technical Analysis – Head and Shoulders

Within the group of technical analysis patterns that are known by all traders, the head and shoulders has a central role. The name is so descriptive, and the pattern so visible, that almost any technical analysis book for beginners starts with this pattern. Before moving into more detail about what it is and what it is not, let’s list the elements of the head and shoulders pattern first:

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How to Treat a Head and Shoulders Pattern

A head and shoulders pattern is a reversal pattern. This is the most important statement to be said about it, and this is the reason why its measured move is not that relevant. Often, traders end up staying only for the measured move, and when this one is completed, they exit the trade automatically. The opportunity cost  in doing that is extremely high, as if head and shoulders are reversal patterns, the new trend has only just begun.

Look for Neckline Retest.

Even though it is not mandatory, there is a strong tendency for the neckline to be retested after its break. This happens most of the time, though, so it is a good indication that the trend that follows a retest is a strong one. The measured move should be calculated only after the neckline can be drawn. We can form an educated guess about this based on the left shoulder’s structure, both in price and in time. The correct way to estimate the measured move is to look at the distance from the head of the pattern to the neckline. Taking that distance and projecting it from the break in the neckline will result in the target for the measured move. Again, the measured move should be seen only as a confirmation that the pattern has worked and the previous trend ended. It is by no means the end of the new trend.
Head and shoulders -1
The EUR/USD chart above shows an ugly head and shoulders pattern that formed on the hourly chart some time ago. It is an inverted one, but the principles and the idea behind trading the pattern are the same for a regular one as well. The two shoulders, while different, show a clear delimitation for the neckline, and the moment the neckline is broken offers a great opportunity to go long. The measured move acts only as a confirmation of the fact that the previous trend lower, that almost vertical bearish trend, is completed. Following that pattern, after the measured move was completed, price fully retraced that bearish move lower. So the head and shoulders pattern did its magic: It worked as a wonderful reversal pattern.
Head and shoulders -2
Imagine the scenario if traders stay only for the measured move: They would miss almost half of the overall trend moving higher. This is because the true nature of the head and shoulders pattern is clearly misunderstood.

Project the New Trend.

Even after completion, the head and shoulders pattern still has plenty of information to offer. It shows the path for the new trend that was born. This new trend is identified by connecting the two higher lows in the head and shoulders pattern described above. The result looks like the following image:
Head and shoulders -3
The information contained in the article that describes the way to use a trendline and how to correctly draw it is very useful here. The principle is the same: We’re just connecting two higher lows with the idea of identifying a new trend, and the resulting trendline to offer the proper place to enter the new trend. It is beautiful how the entry point in the newly formed trend is the same following the retest of the head and shoulders neckline, and the trendline rules. In such an instance, the right direction is reinforced by the fact that two different strategies point to the same trade from the same place.

Because the head and shoulders pattern is such a popular reversal pattern, there is plenty of information to be found by a simple Internet search. While in theory everything looks clear, though, the pattern is distorted, and it takes a lot of practice to be able to “see” when a shoulder is forming, to identify the head and to correctly draw the neckline. As with any patterns, the longer the timeframes they appear on, the stronger the implications. If this is a reversal pattern and it forms on the monthly chart, by the time the measured move is confirmed and the distance travelled, the new trend has bigger implications for the overall picture. Moving forward, we’ll treat one continuation pattern, the bullish or bearish flag, just to show that reversal patterns are not the only ones that can form on a chart. Continuation patterns are equally important, as price often builds energy to break to new levels and confirm the previous trend of a larger degree.

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