Chart Patterns, Friend Or Foe?
Chart patterns are one of they key ways in which technical analysts create trading opportunities and learning to identify clear patterns and develop trade-able parameters around these patterns can help you quickly develop a consistently profitable trading method.
The reason why chart patterns tend to work so well is because although the identification of the patterns is classed as technical analysis, the reason why the patterns actually occur is due to underlying fundamental and order flow. The problem that most traders have with chart patterns is that a) there are a vast amount of patterns and not all are as effective. b) traders are often too keen to jump into any trade that looks like a pattern setup instead of waiting for the crystal-clear, textbook setups that work best.
We are going to focus on just one pattern for now; the Head & Shoulders pattern, which is perhaps one of the best examples of the underlying order flow creating these patterns.
Head & Shoulders
The bearish pattern ( which typically forms as a reversal pattern) consists of four reference points that need to be in place to successfully classify the Head & Shoulders structure; a left shoulder, a head, a right shoulder and a neckline, as shown in the example below.
You can now clearly see where this pattern derives its name from! The reason why this patterns tends to work so well is because of the underlying order flow dynamic at play, which demonstrates a clear shift in market sentiment. The left shoulder represents an initial test of highs whereby sellers step in to drive price back down, towards the neckline however buyers once again step back in and force price back up, clearing the orders initially eroded at the left shoulder, to form a new high; the head. Again, however, supply outweighs demand and price is driven back down into the neckline. Buyers step in once more at the neckline support level but this time are only able to take price as high as the initial high (the left shoulder) where supply again outweighs demand to push price down through the neckline, blowing buyers out of the water, confirming the shift in sentiment. So essentially the Head represents a capitulation to the topside and the neckline represents the key pivot which once broken sees demand outweighed by supply
Trading The Pattern
The above chart shows a clear example of a Head & Shoulders patterns with the clear left shoulder, head, and right shoulder formation underpinned by a neckline.
So how do we trade the pattern? The basic strategy for trading the patterns is quite simple; place a sell order below the neckline of the right shoulder and target the distance between the top of the head and the neckline e.g if the distance from the top of the head to the neckline is 100 pips then the target on your sell order below the neckline of the right shoulder should be 100 pips.
So we can see that we sell as price breaks below the neckline, our stop is placed above the right shoulder and our target is clearly marked and equates to the same distance from entry as that between the head and the neckline.
The above example shows quite a strong “textbook” Head & Shoulders forming along a horizontal neckline with both left and right shoulder forming around the same level, however what you will often find is that these patterns develop along a different gradient and so you may encounter patterns with either an upward or downward sloping neckline
In the above example we can see that we have a Head & Shoulders pattern with a downward sloping neckline, created due to the selling pressure from the left shoulder and head increasing and this driving price lower each time. Some people actually suggest that downward sloping Head & Shoulders patterns work best because the increased selling pressure signals the building strength of supply in the marker. This may well be the case but I haven’t formally tested it yet however.
We trade these patterns in exactly the same way as the regular horizontal neckline patterns.
As you can see in the above example, the increased selling pressure from the left shoulder and the head cause deeper swings in price which create the downward sloping neckline. The premise is still the same though and we sell as price breaks the neckline below the right shoulder, with our stop above the right shoulder level, and we target the same distance as that between the head and the neckline. You can see in this example that we initially retraced higher having broken the neckline, however price did not reach our stop above the right shoulder and we sold off to reach our target.
The regular Head & Shoulders pattern is a bearish reversal pattern but there is also a bullish counterpart, the creatively named “inverse” Head & Shoulders pattern.
Inverse Head & Shoulders
The inverse Head & Shoulders pattern follows exactly the same principles as the regular pattern but forms at lows and signals a bullish reversal.
In the example above we can see a clear inverse Head & Shoulders with the left shoulder, head, and right shoulder structure with a clear neckline in place. As with the regular pattern we simply buy a break of the neckline above the right shoulder with our stop below the right shoulder level, targeting a distance equal to that between the head and the neckline.