Trading the Head and Shoulders Reversal

[RichardCox 10]

Trading the Head and Shoulders Reversal

 

Any successful technical analysis strategy requires us to buy before prices head higher (in long positions) or to sell before prices drop lower (for short positions). This reality has inspired common market maxims like “always buy low, always sell high.” But those of us with trading experience know that it is nearly impossible to forecast true trend tops and bottoms with any regularity. In most cases, we will need to see evidence that the underlying trend is changing before we can establish contrarian positions. There are a variety of ways to do this: Doji patterns, oversold indicator readings, trendline breaks, and Engulfing candlesticks offer some options.

 

In my own trading, some of the best market reversals have been seen with Head and Shoulders patterns (which can also give bullish signals when reversed). One of the reasons I prefer to look for these patterns is that the structures are much more complex than some of the other reversal signals mentioned above. These patterns unfold over broader time horizons and require a much more specific series of events in order to validate themselves. I also believe that these patterns match the spirit of what technical chart patterns are truly meant to do: Visually represent changes in market sentiment. Normally, I try to stick to the facts in these articles and avoid personal opinions but here I thought additional disclosure was appropriate because this is one of my preferred ways to trade.

 

Head and Shoulders Patterns Defined

 

Head and Shoulders patterns signal bearish reversals in an uptrend (shown in the first charted example). Reverse Head and Shoulders patterns signal bullish reversals in a downtrend (shown in the second charted example). In these charts, we can see that prices form a peak in the direction of the previous trend (creating the left shoulder). This is followed by a retracement and then a larger push in the same trend direction (creating the head). Finally, we have one more retracement and a smaller push in the direction of the trend (creating the right shoulder). The pattern should resemble the “head” and “shoulders” on the human body, with each component beginning at roughly similar price levels. This region is then referred to as the “neckline.”

 

Interpreting the Pattern

 

In the standard (bearish) pattern, price behavior is telling is that markets are making an attempt to extend an uptrend, with two higher highs (the left shoulder and head). Warning signals are sent, however, when the third peak fails to create a higher high (creating the weaker right shoulder). At this stage, anyone in a long position should consider exiting the market as there is now building evidence of a reversal. The reverse Head and Shoulders pattern is bullish, signaling the opposite scenario as the right shoulder marks a higher low.

 

Trading Triggers

 

But the pattern can do more than send warning signals for those already in established positions. These patterns can signal new entry points as well. Let’s look again at the standard pattern. Here, we can see that the troughs between the shoulders and the head can be connected using a trendline. It should be remembered that this trendline does not need to be perfectly horizontal, but this line (the neckline) should be viewed as an area of important support. Once prices fall below this neckline support, the pattern is activated and it is time to enter short positions. In the third charted example, we can see a real-time chart Head and Shoulders pattern, where prices form the low peak/high peak/low peak series and break below the neckline. Short positions should be initiated once neckline support is invalidated.

 

The Reverse pattern is used for long positions, and a real-time chart example can be seen in the fourth graphic. In this case, the neckline forms above the pattern, and acts as an important resistance level. Once this resistance level is broken, long positions can be taken as this implies a new uptrend is place.

 

Establishing Price Targets, Setting Stop Losses

 

To construct the complete trade, profit targets and stop losses must be established. In the third and fourth charted examples, the profit targets are drawn out. This is done by measuring the price distance between the extreme point on the head, and then moving back down to the neckline. So, for example, if this is 100 pips, your profit target will be 100 pips after entry (taken after the neckline break). More aggressive traders can elect to close half the position once this target is reached and then move the stop losses to break-even for the remainder. More conservative traders should close the entire position once the objective is hit.

 

Profit targets are relatively clear in these trades. Stop losses are not as clear-cut and will actually depend, to some extent on the size of the profit target. For those with a low risk tolerance, stop losses can be placed 10-15 pips above the neckline (for short trades) or 10-15 pips below the neckline (for long trades). For those with a higher risk tolerance (or smaller position sizes), stops can be set above the right shoulder (for short trades) or below it (for long trades). Most important for stop losses, however, is to maintain a favorable risk-to-reward ratio. So, for example, if the profit target is 100 pips, your stop loss should be no more than 50 pips (2:1 risk-to-reward ratio). This also goes far to determine whether or not you should take an aggressive or conservative approach in these trades.

 

Complex Head and Shoulders

 

Last, it should be remembered that with any technical analysis pattern, there will always be some separation between actual practice and the pre-determined ideal. In some cases, the neckline will be flat, others not. Similarly, the number of shoulder can also vary. For example, when multiple left and/or right shoulders appear, the structure would be classified as a Complex Head and Shoulders pattern. In the fifth and sixth charted examples, we can see a sample structure of what this might look like. Two left and right shoulders are accompanied by the head formation before prices push through the neckline. The underlying reasoning behind these patterns is that the initial trend makes a series of highs and low that support the trend. But when this is followed by highs or lows that suggest a turning point, and an eventual violation of the neckline, a Head and Shoulders pattern is in place. This activity can be used to establish contrarian trades.

 

Conclusion: Head and Shoulders Patterns Offer Reliable Reversal Patterns for Contrarian Traders

 

For traders not readily familiar with the Head and Shoulders pattern, the structures should be considered as an added tool in regular trading. These formations make up some of the most reliable reversal patterns that can be found in technical analysis, and they become easy to identify once you begin looking. Added confirmation of pattern validity can gained using indicator readings, violation of Fib support or resistance levels, or price proximity to Moving Averages as a measure of underlying momentum.

[livernik 10]

''' For example, when multiple left and/or right shoulders appear, the structure would be classified as a Complex Head and Shoulders pattern.'''

 

We could classify '' Complex Head and Shoulders pattern''as the general case ,

1. In case a pattern has no shoulders ( both left and right) but only head , , it remains the ''cup'' pattern

2. In case a pattern has no left shoulders but only head and right shoulder it remains the pattern ''cup with handle''

 

1 and 2 may be considered as subcases of the general case.

[livernik 10]

Richard , Hi,

 

About the calculation of the measured target

 

 

As far as I know the measured target should be calculated by taking the right red arrow - equal to the red arrow from the head and put it on the breakpoint of the neckline -as green arrow indicates. The final target is the green horizontal dotted line. This is the case as neckline is not horizontal in this example.