It is believed that if you look into the abyss for a long time, the abyss begins to look at you. The same happens to a trader when he/she explores a chart for too long, as he/she may begin to see the patterns, which the chart does not contain at all. In this case a trader misrepresents a real picture presented on the chart and makes unsuccessful transactions.
It may seem that identifying the pattern on the chart is the easiest task. They all are described in books and articles; however sometimes we see only what we want to see. One of the patterns, which has confused a lot of traders is the pattern «head and shoulders» and we will talk about in this article.
Building up a pattern and its operating principles
Head and shoulders is a reversal pattern, which helps to predict further price behavior. Unfortunately, this pattern is formed on the chart not as often as traders expect.
The basic principle of building up this pattern is the formation of three tops, the middle one of which (head) is higher than two others. This pattern shows that both the bulls and the bears had repeatedly tried to take a lead; finally both of them lost strength and as a result the trend has reversed changing direction.
The right shoulder of the pattern represents the last attempt to take over, which was unsuccessful.
The problem is that many traders see this pattern on the chart when it is not there, as it is possible to plot this pattern almost on any part of the chart. It happens that experienced traders can filter out false images, while the beginners take them as real patterns.
In the pattern «head and shoulders», the left shoulder is always slightly below the right one and the head is higher than both of them. You can see this pattern on any timeframe, but a trader shall remember that there are more chances of false image on the lower timeframes.
The formation of the pattern «head and shoulders» on the chart is a signal to open a trade. There can be both direct patterns and reverse ones; the patterns giving signals to buy or sell.
The chart above shows a pattern giving a sell signal. In order to determine an entry point a trader shall draw a line from the bottom of the left shoulder to the bottom of the right one. Breakdown of this line is a signal to open a trade.
Our example shows an aggressive signal, as we do not know whether the formation of the pattern has completed or not, as the formation of the right shoulder can continue. For a conservative entry, a trader can wait until the first candle closes under the signal line. At the same time, after the completion of the pattern, the price can jump, that is why if a trader waits for the conservative signal, he/she can miss part of the profit.
It is recommended to place a stop loss stop order on the upper point of the right shoulder and gradually transfer it to the break-even zone. For determining a take-profit point a trader shall count the number of points from the top to the bottom of the head, from the highs to the point from which the right shoulder begins to form.
This number of points is added to the price and this will be the point where we place take-profit order. A trader shall remember that take-profit can be transferred, as well as the stop-loss and the entry points should be determined with the help of other strategies or patterns.