Head and Shoulders Pattern

FX Strategy Video > Forex Chart Patterns

The Head and Shoulders Pattern is a strong reversal signal that normally gets traders to sit up and take notice. There are two variations of the pattern, the normal head and shoulders, and the “inverse” head and shoulders. The head and shoulders pattern appears at the top of an uptrend, while the “inverse” or “upside down” head and shoulders forms are the bottom of a downtrend. Both of these patterns are trend reversal patterns.

The shape is names because of the three peaks (or valleys) that make up the pattern. The middle peak is considered to be the head, and the two lower peaks are considered to be the shoulders as they are on either side of the head. There is also a “neckline”, which is at the bottom (or top in an inverse pattern) of the pattern that signals a confirmation of the pattern sending a trading signal. The beauty of the pattern is that it comes with a measuring stick or sorts – the height. The highest point of the pattern to the neckline should be measured, and then subtracted (in the case of the normal head and shoulders) or added (in the case of the inverse head and shoulders) to the point in which the breakout of the neckline happens.

If you think about the psychology of the pattern, it is easy to see why it is so important. The chart that is attached shows that an uptrend formed, and buyers certainly would have been encouraged by the rapid ascension of price. The second peak formed when the buyers took control again, this time pushing the price even higher. By now, they certainly would have been quite happy with their positions. However, once price retreated and attempted another push higher, the buyers couldn’t. This would have the buyers concerned. By the time the neckline gets broken, almost all buyers are now losing money and they are quickly exiting the buy positions by selling – pushing prices even lower.

The upside down version works in the exact same way, but reversed. In other words, the sellers are in control, and push prices to a new low. The expected bounce happens, and then the sellers continue to push lower yet again. At this point, the head is formed as the market bounces again. But on the third attempt, the sellers suddenly find they aren’t able to make lower lows. Once the neckline gets broken, it only confirms the sellers are losing control.

Published on 15th of July 2011
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