The Head & Shoulders Pattern – Part Two

Further Ways To Trade

Following on from part one last week where we introduced the Head & shoulders pattern and started to look at the basic ways we can trade the pattern and the different ways in which the pattern can set up, we’re now going to look at some further ways you can trade the pattern.

Trading A Retest Of The Neckline

We’ve already discussed the most commonly used method for trading Head & Shoulders patterns, however a slightly more strategic way to use these formations is to look to trade a retest of the broken neckline area.

As we talked about in our support and resistance webinar, the shifting order flow dynamic at key levels in the market means that they are often changing between support and; the neckline of a head and shoulders pattern is a great example of this.

The neckline acts as support for the pattern formation driving price back up each time price comes down into that area due to the strong demand at that level. However, once price breaks down below the neckline after coming off the right shoulder supply has eclipsed the demand at that area and so instead of acting as support we can now anticipate that due to the change in order flow at that area, it will now act as resistance.  So for those traders who are a little more conservative and like to wait for extra confirmation before trading, waiting for a retest provides exactly that confirmation.has6

In the example above we can see a really clear Head & Shoulders pattern in NZDUSD. Price breaks down through the Neckline of the pattern before reversing to trade back up and retest the underside of the broken Neckline. Price fails at the retest of the broken Neckline and sells off in line with the original breakdown through the Neckline.

This is a great example of how you can look to use a retest of the Neckline as added confirmation for trading Head & Shoulders patterns. The failure at the Neckline retest confirms to us that shift in order flow at that levels and creates a high probability set-up for us to take advantage of.  Now obviously not all Head & Shoulders patterns will see price trade back up to retest the broken Neckline but as we discussed in the Breakout trading series, trading a retest is a more conservative and strategic way of using these patterns to boost your bottom line.

Calling The Right Shoulder

Trading a retest of the broken Neckline is a more conservative approach to trading the Head & Shoulders pattern but there is also a way that you can be a little more aggressive in how you trade this pattern. Traditionally we wait for the right shoulder to develop before trading a break of the Neckline however some traders actually look to enter at the area that they anticipate will be the Right Shoulder. The trade is obviously more risky but if done correctly can yield good results as you gain a premium entry to the pattern and the subsequent breakdown.

The way in which this trade is typically entered is by plotting a horizontal resistance level on the chart from the high of the Left Shoulder. A short trade is then placed as price trades back up into this level in anticipation of price reversing lower. has7

In the example above we can see a clearly defined Head & Shoulders pattern; notice how the Right Shoulder forms at the same level that the Left Shoulder formed. This is quite a common occurrence with Head & Shoulders patterns and creates the opportunity for an earlier yet higher risk entry to the trade.

Some traders will simply trade the levels strike with a stop above the Head. However I feel that as we are already looking at taking a higher risk trade we are better waiting for some confirmation and so I will only take these trades where there is price action confirmation such as bearish pin bars or bearish engulfing candles. has8

Looking at the example again we can see there was a really nice bearish pin bar at that level that we could have used as an entry point. Now obviously not all Head & Shoulders patterns form with the Right and Left shoulders at the same area; we looked in the first article at patterns that form with downward sloping Necklines which can often see a lower Right Shoulder form.  However if you are looking to use this method then stick to the very clearest setups that form with as close to a horizontal Neckline as possible and wait for a price action entry point, this will increase your chances of success with this method.

The various ways you can trade the Head & Shoulders pattern make it a very versatile pattern indeed and means that it is suitable for all trader types and risk profiles, so spend some time getting familiar with identifying the pattern and hopefully you will be able to incorporate the pattern into your trading strategy portfolio.

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