Posted on: 23 Nov, 2018
If you are interested in expanding the carrousel of strategies to trade the constellation of currencies in the foreign exchange market, this article explores what’s arguably one of the most popular out there. Yes, I am referring to the head and shoulders strategy.
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If you are interested in expanding your personal arsenal of strategies to trade any constellation of instruments in financial markets, this article explores what’s arguably one of the most popular out there. Yes, I am referring to the head and shoulders strategy.
Don’t trust me? If you run a simple google search, guess how many results come up for the term “head and shoulders pattern”? That’s just a touch shy of 70M!
Against conventional belief, my explanation on how to trade this pattern may be in some ways counterintuitive to how it is formally explained in the academic realms. There are tonnes of information out there as the illustration above proves, but for the most part, you really need to question its true value judging by the method of entry endorsed.
Let’s first dive into what this pattern constitutes and why the term head and shoulder.
Firstly, the set-up communicates the risk that the market may be carving out a potential top or bottom, hence a trend change might be in store. Secondly, as the pattern name indicates, it’s term originates from the fact that the shape looks identical to our constitution as humans, 2 shoulders and a head.
Allow me to briefly touch on the anatomy of the pattern. In a bull trend reversal situation, it consists of a left shoulder, which on an uptrend could be price making a new high (left shoulder). The high is followed by a small retracement only for the price to print higher highs (head). This new peak is then followed by a pullback deep enough to come close, retest or break the previous low, from where another rebound that falls short from reaching the previous high is seen (right shoulder).
In an ideal case, the high of the right shoulder or second shoulder should align with either the high of the left shoulder or at least with the level of reference as part of the first shoulder that had the most interactions. Note, this concept should be taken with a pinch of salt, as most of the times, the shoulders fail to be perfectly shaped, and that’s ok.
Similarly, a textbook example would have us believe that the distance or time it will take between the formation of the left shoulder to the head should be analogous to that of the head to the right shoulder. Again, don’t get caught up in finding immaculate precision. Formations are far from perfect in terms of symmetry or waves, with usually some erratic moves between the shoulders and head. Always look to take a pragmatic and flexible approach when analyzing these patterns.
Lastly, the neckline can be identified after there is sufficient evidence that the second shoulder is forming. Simply draw a horizontal line through the lowest of the shoulders. The pattern would be confirmed, and that’s how it’s taught to be traded. The price breaks through the neckline and hopefully finds acceptance below the neckline.
Just be aware that in many occasions, the neckline may not be perfectly horizontal in alignment, in which case, you may draw it with an ascending or descending trendline. If that's the case, the break of the trendline neckline would represent the confirmation of the pattern, even if later I will rationalize why this type is weaker in nature.
This pattern below is referred as a head and shoulders top. The opposite is true if trading the pattern from the bottom side, it’d signal a potential bullish reversal.
So, what do I mean when I question that the entry method taught out there is not ideal? Let’s click the very first result that comes up via google. Wikipedia.
What do you notice in the above snapshot? Yep, the obsession that exists to highlight the relevance of the neckline, which leads to every trader and his/her dog with a tendency to trade the pattern when it’s confirmed. When is that? Well, as you could read above, when the ‘overrated’ neckline gets broken.
You can’t be blamed if you are trading this way, and maybe it works for you. That’s just what’s taught in the retail space. As humans, we are wired towards certainty far more than we want to believe or accept. It’s in our DNA, and it’s been this way since our ancestors the Neanderthals had to save their tails by developing 'survival' instincts.
We’ve developed this sense of avoiding pain (uncertainty) and find comfort in the shelter of certain outcomes. That’s why the break of the neckline offers such a reassuring moment of temporary calm. We know we are only entering the trade when the pattern is finally validated.
However, as traders, please pat your back if you believe the anticipation of an outcome is far superior as a skill compared to the outcome itself. The outcome, if you think about it, is just the by-product of having rightfully anticipated a pattern to occur. Wouldn’t you agree?
Therefore, I'd like to provide unrefutable evidence about the reasoning why from a risk-reward perspective, you’d be better off trading the 2nd shoulder formation.
When we enter a trade, all we are doing is accepting the risk of participation in a trade to find out if our initial thesis is valid. We'd then be in that 'modus operandi' until the profit taking level is reached or the thesis we based our trade on is no longer valid.
Until here, we are on the same page, right? Therefore, if you are trading the break of the trendline, it’s fair to assume that the pattern would be dimmed as a failure and be technically negated if the break of the neckline leads to a retest and break of the 2nd should back up again, correct? That’s where the majority of stops will be placed.
Here is the kicker. In many cases, trading the break of the neckline forces you to broaden your stop to a distance that makes it harder to achieve an attractive risk-reward. Conversely, if instead, you trade based on the expectation that the 2nd shoulder will be formed, you place yourself, from a risk-reward standpoint, in a far better position. You can get to reduce the stop size by over 50%, if not more, before finding out whether or not the trade validates your thesis based on your study.
In the example below, I demonstrate how the entry on the breakout of the neckline barely achieves a 1:1 risk reward as the stop would most logically have to be placed beyond the low of the 2nd shoulder, that’s where we can gather enough evidence that the pattern did not play in our favor.
On the flip side, by entering the trade somewhere in alignment with the first shoulder’s swing low, you’d then guarantee a chance to participate in the formation of the structure, yet your risk to reward is far more attractive. Like 4 times more appealing at least.
In some cases, as the first example I shared above, the 2nd shoulder entry type may not offer an advantageous stop loss distance based on the assumption of where stops are placed in each entry type. This tends to occur when the pullbacks that form the shoulder are limited in nature.
However, by and large, if you stick with an entry in anticipation of a 2nd shoulder formation, over time, the risk-reward opportunities will far exceed the ones you will expose yourself to by blindly following the herd mentality (neckline breakout entry).
What other clues can we obtain as part of a head and shoulder pattern that would give us early indications that the test of the 2nd shoulder holds value?
One key element to always keep track is both the acceleration and the magnitude of the movement in the formation of the head sequence. The stronger the impulsive departure and what it achieves, the more chances that when/if revisited, the 2nd shoulder will offer value as a reference point for an entry.
Types of heads:
Type 1: This is the best case. It consists of a strong imbalance of demand or supply that break above or below the 1 shoulder’s swing high/low. It achieves what’s often referred to as a break of structure, hence why a retest of the point of reference created by the 2nd shoulder represents an attractive proposition.
Type 2: Subject to the market context, this is a sequence that should be categorized as acceptable to trade. While the move from the head’s high doesn’t achieve a break of the 1st shoulder, the impulsive movement definitely adds credence to the 2nd shoulder trade entry.
Type 3: This is the type of formation that you should stay away from. Even if the rejection off the lows that allow creating the head is impulsive, it never accomplishes any break of the structure. In this scenario, no considerations should be given to trade the 2nd shoulder. If anything, you could wait and trade the break of the trendline, in which case, the stop placement would be, in my opinion, way too large as highlighted above.
Another critical point is the symmetrical traits of the head and shoulder pattern. I’ve emphasized not faling into the trap of being too precise when trading the pattern. You will be hard-pressed trying to find head and shoulder sequences with an exact symmetrical composition. That’s why I suggest making the study of the pattern flexible in nature, allowing some room for misalignments between the distances from the shoulders to the head.
However, there should be limits to how tolerant you get to be. If the test of the 2nd shoulder occurs at a time when the context of the pattern has completely lost its relevance given what’s occurred, in terms of price action, since the test of the first shoulder, it no longer makes it a tradable valid pattern.
Allow me to explain with a couple of chart illustrations what I mean. In the first example, there is a relatively similar distance between each relevant swing low.
On this second example, the symmetry is completely off, as the time that it takes for the 2nd shoulder to test the level of reference from the 1st shoulder is out of whack. There is a new structural context that develops between the head and the 2nd shoulder, which would make defeat the purpose of trading the pattern.
If we ask ourselves, why does this pattern work? Let’s break down what’s really happening from an order flow perspective.
In an uptrend, as the price makes higher highs by breaking through the first shoulder, new players add long-side positions. This equates to a market with stronger open interest in long-side commitment in the majority of cases. However, the selling flows that originate off the head formation, result in a change of perception that forces the previous buyers to make a re-assessment and probably be less aggressive as they notice new players (sellers) may take control.
It’s during this phase from the build-up of the head up to the 2nd shoulder that the most interesting shift in the market psyche occurs. Buyers who are still holding longs are left with a choice, they either keep pushing higher for a new attempt into the previous highs, or they aim to bail out around breakeven.
Guess where that breakeven point is? Where the 2nd shoulder tends to be formed.
So, it’s at that level where you have, at times, the combination of buyers bailing out of their longs, hence exerting selling pressure. At the same time, we get the increasing sell-side interest by those that first engaged in the aggressive selling that originated the head in the first place.
So, after disseminating the ins and outs on how to best trade the pattern, hopefully, this article gives you a new perspective to trade it for the most optimal risk-reward.
If there is a key takeaway from this article, it should be that patterns hold an extremely powerful effect on the basis that they create a perception of opportunities if judging the historical price behavior. But even more important is how to exploit these opportunities.
The general belief continues to be that the pattern will only be validated after the breakout of the neckline. However, as I’ve attempted to demonstrate in this article, you can recalibrate your approach by finding that 2nd shoulder area where you know if you get it right, you will be able to extract the most profit out of the market.
At the end of the day, as a trader or investor, you want to find positions in the charts that allow you the most bang for your buck, right? That’s what risk-reward is about and why the 2nd shoulder should be the best companion when looking to exploit the head and shoulder pattern.
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