Trading patterns in the charts
Many people believe that the patterns on the charts are simply lines that are drawn with colored lines, and those magically things indicate changes in trend or continuation of trend.
That’s a basic and simple way of saying it, but do you really think it’s just lines, because the truth is that it’s not, I’ll explain.
Chart patterns are one of the most useful tools for traders and investors. Chart patterns do not predict the future, but are known to be more likely to develop in a particular way. They are used to identify signals of trend continuation or changing trends (reversal pattern).
Those patterns can help a lot in trading, to know when to buy and when to sell.
Head and shoulders pattern
There are patterns so effective and interesting, that over the years have become legendary patterns, such as the bullish and bearish flags, the wedges, the pennants, but especially the pattern we will talk about here, the Head and shoulder (Bearish) or the inverted Head and Shoulder pattern( Bullish).
According to the theory this is a trend reversal pattern or continuation pattern, which means that generally when this pattern appears it, is possible that a change of trend is in the making whether it is downward or upward. But, first let’s talk about patterns, shall we?
Like everything in life, on many issues not everyone agrees, be it economic, political or war issues, not everyone enters into consensus, but many times a majority is able to create more pressure than a minority, and therefore take control of the situation.
This happens this way in the markets themselves, the markets are places that could be in total balance between supply and demand, between purchases and sales, when that balance is presented the price tends to stagnate, because it does not rise or fall, it only remains in a zone of congestion.
Now, when at some point an imbalance is created between the two forces, the market moves in the direction of force majeure, if it is the buyers it moves upwards, and if it is the sellers it moves downwards, this is where we note that the imbalance is vital for there to be movement in the market.
The H&S pattern is generally a pattern of change in trend but remember it could be also a a continuation pattern, according to the theory; it repeats itself a lot and has been very reliable over the years.
Bearish head and shoulder pattern
Head and shoulders pattern is formed when the price is making three new lows:
- The first of them (left shoulder) makes it with good volume, indicating strength.
- The second high (the head) deeper than the previous one makes it with less volume, indicating less strength.
- Finally the third of them (right shoulder) makes it with even less volume, indicating less strength, and at a similar level to the firstlow (left shoulder).
- The resistance line that connects the three highs is called the neck line and is vital when trading this pattern.
- With this pattern a target can be projected, and it is done by measuring the distance between the neck line(resistance) and the top of the head, projected from the break of the same neck line by the right shoulder.As shown in the figure (red line).
Inverted head and shoulder pattern(Bullish)
Inverted H&S pattern is formed in an antagonistic way to the normal head and shoulder pattern:
- Price has been making 3 new lows.
- The first one (left shoulder) does it with good volume, which indicates strength.
- The second one (head) lower than the previous one does it with less volume, which indicates less strength.
- The third one (right shoulder) does it with even less volume which indicates less strength, and at a similar level to the first minimum (left shoulder).
The line that connects the three lows is called the neck line as is the normal pattern. And the projection of the low is done in the same way, only inverted and upwards, i.e. the distance from the neck line to the lowest point of the head is measured and projected from the break of the neck line by the right shoulder.
More upwardly inclined the neck line is, the better, as it indicates greater weakness in the current trend and strength in the upward trend.
Continuing Trend Patterns
With continuing patterns the highest probability is that the price will follow the trend established so far. Trends tend to last longer than anyone has anticipated, so it is always the safest option to trade. This means that if you encounter an inverted head and shoulder in an uptrend, chances are that the trend will continue up.
Different Head and shoulders patterns
It is not uncommon to see head and shoulders patterns whose structures are composed of two or more heads, several shoulders, even shoulder-head-shoulder patterns that looks sloped.
Regardless of the structure of the pattern, all of the above is valid depending in some factors, position of the pattern, volume conjunction with other indicators, etc .
The following graph we have an example of a multiple shoulder-head-shoulder pattern, in this case composed of a head and several shoulders on the left and right.T
In contrast, we can find them tilted upwards and that would be an ascending head and shoulders pattern.
We have to be a little bit open minded when spotting this kind of patterns and follow the logic of the movements.
How to trade the head and shoulders patterns
Always it’s good to have a plan, and it should be structured in this order:
- Entry price: the point where you are going to buy.
- Stop loss: price where you will leave the position if it moves against you.
- Target price: price/s at which you want to sell to get and keep profits. It is always a good idea to leave a small portion of your shares in case it keeps going up.
You may wonder why I define the stop-loss before the target. It is better to be aware of how much you could lose if your trade goes against you, and only when you have accepted it you should determine the possible profits. It is easy to get emotional when you have not previously defined what you will do in each situation and end up making bad decisions.
It is common for the price to come out of a pattern to fall back into it, and then even break in the opposite direction. Patterns can evolve and change from one to another.
We will trade this pattern the same way if it’s an inverted, normal, reversal or continuation and we will do it in this way:
- It’s important to know the target, with this pattern we can do good price projections, so use it in your favour to have an exit plan and find your target, but be aware of resistances , gaps, etc. and trade accordingly with anatomy of the chart.
- We can place the stop-loss bellow or above the shoulder depending if it’s an inverted H&S or a normal head and shoulder.
- Get in after confirmation: after breakout or before breakout if we see good volume.
- There is always an opportunity to get into the trade, expect pullbacks and support retests. The more cautious we are the more money we will make.