The head & shoulder pattern is a technical analysis tool used for spotting trend reversals. This subjective and sophisticated shape – Head & Shoulders, is made at the highest or bottom of a trend, upwards or downwards, respectively.
This short article includes a simple to read guide on this pattern. It might be followed by discussing some pros and cons, and eventually, we'll understand the science behind this pattern. In other words, you will understand why this pattern works so well, followed by an honest conclusion
Head & Shoulder Pattern: Advantages
- Easy This pattern is sort of easy to identify on the trading chart compared to other technical indicators. It can be seen frequently.
- Omnipresent It is not confined to any particular market. Be it stocks, FOREX trading, indices trading, commodity, or any other financial markets; one can use it anywhere.
- Calculative Risks This pattern features an excellent potential to spot significant market value movements. Unlike other tools, it takes a calculative risk and rational profit levels.
Head & Shoulder Pattern: Limitations
- Not for Everyone It is often quite complex to know or identify novice players & is usually not suitable for noise traders who don't have complete knowledge.
- Time Taking The waiting time is long because it requires the pattern to form ultimately. It also can make traders miss some good opportunities.
- Not for Volatile Markets It is confusing for a volatile asset as there would many ups & downs; thus, forming many shoulders. One peak is a 'Shoulder' for somebody, while for another person the same is 'Head'. The price line can return after forming the 'Head & Shoulder' pattern and thus, confuse traders.
Knowing the pros and cons of the trading tool you would possibly use is the initiative.
"Head & Shoulder" Pattern: Step-by-Step Guide
- Determine the Trend The primary step in our guide is to spot the trend from the trading chart. This pattern requires a currency to be already in a downward or upward trend. Moreover, the longer the duration and sharpness of the trend will be, the more strong probabilities of reversal occurs.
- Confirm the pattern The second step is to verify the "Head and Shoulder" pattern. A trader should wait till the top of the Head is hit and then start planning his further moves. Stepping into the market early can cause you to suffer losses.
- Plan the Prices Once the trader confirms that the pattern is forming, he should start planning at the top of the Head. Price levels like stop-loss, entry and exit points should be within the traders' minds before reaching the trade level. Also, carefully set your benchmark and don't greed or fear here.
Tip: You can also take the assistance of price predicting tools like moving average, support & resistance, and Fibonacci.
- Form a Neckline Now, the time is to form a neckline. It is made by connecting the points of low points of the Head. Remember, the only breakage of the neckline fully confirms the pattern.
- Trade This step is to put the orders and set stop losses. If you would like to start early, try starting at the right shoulder's high point by short selling. Therein, set the stop loss at the very best upper end of the Head.
- Watch Your Profits Now, the last step is to ascertain your profits grow in multiples. Keep an eye fixed on the price line daily or a minimum of every 2 to 3 days. Also, be in-tuned with the news, journals, and events associated with your traded currency.
So, this was a step-by-step guide to trade with head & shoulders pattern. Any trader, whether experienced or novice, can use it. However, it might be better if you clear your essential homework first and then attempt to trade.
Now, let's enter understanding the science behind this tool and why it works so well!
Science behind the top & Shoulder pattern
As a trader, you should understand why a particular tool is working or not. The Head & Shoulder tool might not be the best, but it works primarily due to a specific reason. The first thing you would like to know is – When prices fall, it means the sellers are dominating, or more people are selling the currency. And, when prices rise, it means the buyers have the advantage.
Now, as the market approached the very best point of the Head and commenced falling, the sellers start to enter the market. It's because the market has rejected the very best price index, and the line would fall. However, the falling prices attract some buyers and make the trading line rise again but not as high as Head.
But, soon, it starts to fall again, and therefore the buyers realize that they're in losses and panic; they sell their asset. This panic selling by these novice/noise traders change the general trend and make the upward trend a downtrend. The last sellers among them face high losses before exiting the market. Thus, causing the market to fall further and approach a subsequent low price target.
Head & shoulder may be a useful gizmo to earn money. Many traders still follow the traditional method of trading. However, with the assistance of this tool, you'll also take advantages of falling prices by a short sale. Short selling is to first sell at a higher cost without owning the asset then buys an equivalent asset at a lower cost.
Also, regardless of how vital this tool is, the market is unpredictable and thus risky. It can eat up your hard-earned money quickly. The rationale is other big investors are sitting there too, who earn barely from trading. They play with the psychology of noise traders and make money.
In all this, you'll also lose. Thus, it's crucial to place stop losses and limit levels when trading in FOREX.
Keep learning, keep growing!