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Head and Shoulders (Technical Analysis)

In this entry I’ll go over Head and Shoulders (no not the shampoo). The Head and Shoulders is a price action based trading pattern. The formation occurs at the end of uptrend (for a Head and Shoulders Top) or a downtrend (Head and Shoulders Bottom) and is considered to point to a change in trend.

Head and Shoulders Top

The Head and Shoulders Top pattern consists of a left shoulder, a head and a right shoulder. The peaks printed by the two shoulders are around the same price. The head in the middle has a peak that is higher than the highs of the two shoulders that surround it. This chart pattern looks like a head with two shoulders, hence the name. Here’s a good example of this PA formation on a EUR/USD Daily chart.

The high of the first shoulder was at 1.3320. The head peaked out at 1.3485. The right shoulder had a high of 1.3384. We marked the pattern with a few lines to make it easier to spot. Notice that while this formation doesn’t look EXACTLY like a head with shoulders (there’s an extra shoulder to the right), it is close enough. You can never find perfect chart examples ‘’in the wild’’.

Head and Shoulders Top – Entry, Stoploss, Take Profit

The lowest low marked by the valleys between the three peaks stood at 1.2974. This is called the ‘’neckline’’. A break of the neckline means that the H&S pattern is confirmed. Our short would be initiated at 1.2974. The logical place for a stop is just above the highest high of the formation, in our example this would mean placing the stop above 1.3486 (high + 1 pip spread).

As indicated by the pic above, the total risk on our short was 512 pips, not bad for a Daily chart signal. After prices broke the neckline, the EUR/USD proceeded to hit the 1R target in less than 1 month.

Head and Shoulders Bottom

The Head and Shoulders Bottom pattern consists of a left shoulder, a head and a right shoulder. The troughs reached by the two shoulders are around the same price. The head in the middle has a trough that is lower than the lows of the two shoulders that surround it. This chart pattern looks like an upside down head with a shoulder on each side. Here’s a good example of the H&S Bottom on a EUR/USD Daily chart.

This example happened few months after the Head and Shoulders Top formation we discussed previously. This pattern also doesn’t look like a perfect H&S, the low of the second shoulder is somewhat higher than the low of the first. Still, it is a decent enough example. On a Daily chart you can’t afford to wait for that perfectly looking Head and Shoulders. Try looking for a perfect H&S formation on the lower timeframe charts, you’ll get a lot more examples to choose from. However keep in mind that the lower you go in TFs, the more transaction costs will start to impact your profitability.

Head and Shoulders Bottom – Entry, Stoploss and Takeprofit

The entry for the Head and Shoulders Bottom is the same as for the Top, a break of the neckline. In our Bottom example, this would mean going long the Euro at 1.2747 (neckline + 1 pip spread). With a stop placed below the lowest low of the formation, the total risk on the trade was 706 pips. Compared to our Head and Shoulders Top example, the EUR/USD took a lot longer to reach the 1R target. The entry was initiated on September 7th 2012. The 1R takeprofit area at 1.3452 was hit on January 25th, over 3 months after the long position would’ve been taken. This is not that unusual, financial market tend to rise much slower than they fall. The reason for this is because fear is a much stronger emotion than greed, The chart below shows the entry, the stoploss and the take profit for this trade.

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