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Showing results for tags 'head and shoulders'.
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The Death Triangle: Looking at a Variation on the Head and Shoulders Pattern One of the biggest problems in the approaches generally taken by chartist traders is the tendency to over-rely on backtesting and simple probability figures at the expense of really looking at what price patterns are telling us about market sentiment. There is a reason, for example, that a Descending Triangle pattern is considered to be bearish, and there are clearly definable explanations for why short positions should be taken once the foundational support level in that pattern breaks. The same is true for flags, wedges, harmonic patterns, double or triple bottoms, etc. So what tends to get missed when we look at backtesting statistics (which give only limited information for how an asset is likely to trade in any given situation) is the underlying philosophy and rationale behind these patterns. It is important to remember that the the map is not the territory, the menu is not the meal. And there are many cases where traders might see markets unfold in ways that might not exactly match the textbook criteria for a specific pattern. One pattern that should be considered here is the Death Triangle, which uses some of the same rationale that is seen in a Head and Shoulders pattern. It is valuable to have some idea of how patterns like these inter-relate because it can be helpful in avoiding missed opportunities once they are present in the market. Head and Shoulders Structure First, let’s take a look at the commonly accepted structure for what a head and shoulders pattern should look like. There are some differences of opinion in which rules can be broken here but most traders would agree that the structure shown below would qualify: These structures take place in an uptrend, form a left shoulder, rally further (creating the head), and start to lose momentum until the neckline is finally broken. Stop losses could be placed above the right shoulder, and the profit target is generally located using a pip distance that is equal to the distance between the head and the upper price point found at the head. Above, we can see what the pattern might look more like in actual trading practice. Overall, the head and shoulder pattern is highly effective in pinpointing the ‘topping out’ period in a uptrend and can be used to short sell an asset. Structural Parameters But while this pattern is great for spotting these special circumstances, the reality is that markets don’t need to fit the textbook criteria. So, what happens if the shoulders are not equal? What happens is the neckline is not level? Is the structure still valid? Can short positions still be taken? The main point here is that waiting for textbook conditions will mean that you miss trading opportunities. Instead, it is much more important to look at the underlying rationale that delineates the pattern. What the head and shoulders pattern is meant to define is a topping structure, where the initially bullish momentum starts to give way until we start to see major support breaks. This means that the right and left shoulder do not need to be equal in order to be identified as a tradable scenario. In fact, there are instances where unequal shoulder levels will actually go further to match the rationale behind the pattern. The Lower Right Shoulder Specifically, consider the pattern with a lower right shoulder. Some traders might argue that this invalidates the pattern. But what is the real rationale that should be considered here? The main concept in the head and shoulders structure is that prices have reached a peak that they were not able to match again. A true uptrend is marked by a series of higher highs and lows. But when prices are only able to form a shoulder (and not a higher head) it essentially suggests that the market momentum is changing. But if the right shoulder is lower than the left, it is an indication of an even more forceful turn in momentum. This will only increase the probability for successful short positions as there is less of a reason to argue that the original uptrend is still in place. In a structure like this, we can see an example of how a trader that only obeys the textbook rules would have missed what is actually a much better trading opportunities. I am reminded here of the time when my football coach said that “the worst type of player is the one that never follows the coach’s rules -- but its also the one that does nothing but follow the coach’s rules.” The lesson here is that there will be plenty of instances where you will need to read the situation and identify times where the spirit of the pattern is being met even if the textbook criteria is not followed to the letter. The Death Triangle Another example here can be found in the Death Triangle, which is essentially a variation on the idea of the head and shoulders formation. Below, we can see the topping formation that begins after an uptrend and results in a major change in the market’s underlying momentum: In the above example, we can see price action that would be difficult to describe as a head and shoulders formation. But most of the important parts in the structure remain, and this is another structure that could be used to establish short positions in the asset. After the uptrend starts to turn, we see a pyramid-like structure that ends the previous series of higher highs and leads to a major support break. Sound familiar? It should, and this is because it is the same rationale that supports short positions taken once a head and shoulders is spotted. But if you chose to wait for three exact price levels that would fall into the commonly watched head and two equal shoulders, you would have missed out on the massive downtrend that was signaled by the ominous-sounding death triangle. In this pattern, we can see another example of how a commonly watched pattern should be viewed with some degree of flexibility. As long as you can still make a reasonable argument for lower prices, most of the same trading parameters can still be applied. Look to establish a profit target that is roughly the distance between the triangle base and the highest high in the formation. This is because prices tend to move in waves, and those waves tend to be similar (although not exactly similar) in value. Conclusion: Watch For Price Patterns But Don’t Restrict Yourself To Textbook Definitions In the example above, we can see that traders should not limit themselves to the textbook definitions when structuring new trades. This can lead to many missed trading opportunities and an imperfect understanding of how the market actually operates. The market will never obey the structural parameters in any pattern, as much as we would like to wish it would. Because of this, we need to allow some degree of flexibility and pay more attention to the rationale behind the pattern, rather than the pattern itself. This will open up your position to a much wider range of options and give you a better sense of what is actually happening in the market at any given time.
Trading the Head and Shoulders Reversal Any successful technical analysis strategy requires us to buy before prices head higher (in long positions) or to sell before prices drop lower (for short positions). This reality has inspired common market maxims like “always buy low, always sell high.” But those of us with trading experience know that it is nearly impossible to forecast true trend tops and bottoms with any regularity. In most cases, we will need to see evidence that the underlying trend is changing before we can establish contrarian positions. There are a variety of ways to do this: Doji patterns, oversold indicator readings, trendline breaks, and Engulfing candlesticks offer some options. In my own trading, some of the best market reversals have been seen with Head and Shoulders patterns (which can also give bullish signals when reversed). One of the reasons I prefer to look for these patterns is that the structures are much more complex than some of the other reversal signals mentioned above. These patterns unfold over broader time horizons and require a much more specific series of events in order to validate themselves. I also believe that these patterns match the spirit of what technical chart patterns are truly meant to do: Visually represent changes in market sentiment. Normally, I try to stick to the facts in these articles and avoid personal opinions but here I thought additional disclosure was appropriate because this is one of my preferred ways to trade. Head and Shoulders Patterns Defined Head and Shoulders patterns signal bearish reversals in an uptrend (shown in the first charted example). Reverse Head and Shoulders patterns signal bullish reversals in a downtrend (shown in the second charted example). In these charts, we can see that prices form a peak in the direction of the previous trend (creating the left shoulder). This is followed by a retracement and then a larger push in the same trend direction (creating the head). Finally, we have one more retracement and a smaller push in the direction of the trend (creating the right shoulder). The pattern should resemble the “head” and “shoulders” on the human body, with each component beginning at roughly similar price levels. This region is then referred to as the “neckline.” Interpreting the Pattern In the standard (bearish) pattern, price behavior is telling is that markets are making an attempt to extend an uptrend, with two higher highs (the left shoulder and head). Warning signals are sent, however, when the third peak fails to create a higher high (creating the weaker right shoulder). At this stage, anyone in a long position should consider exiting the market as there is now building evidence of a reversal. The reverse Head and Shoulders pattern is bullish, signaling the opposite scenario as the right shoulder marks a higher low. Trading Triggers But the pattern can do more than send warning signals for those already in established positions. These patterns can signal new entry points as well. Let’s look again at the standard pattern. Here, we can see that the troughs between the shoulders and the head can be connected using a trendline. It should be remembered that this trendline does not need to be perfectly horizontal, but this line (the neckline) should be viewed as an area of important support. Once prices fall below this neckline support, the pattern is activated and it is time to enter short positions. In the third charted example, we can see a real-time chart Head and Shoulders pattern, where prices form the low peak/high peak/low peak series and break below the neckline. Short positions should be initiated once neckline support is invalidated. The Reverse pattern is used for long positions, and a real-time chart example can be seen in the fourth graphic. In this case, the neckline forms above the pattern, and acts as an important resistance level. Once this resistance level is broken, long positions can be taken as this implies a new uptrend is place. Establishing Price Targets, Setting Stop Losses To construct the complete trade, profit targets and stop losses must be established. In the third and fourth charted examples, the profit targets are drawn out. This is done by measuring the price distance between the extreme point on the head, and then moving back down to the neckline. So, for example, if this is 100 pips, your profit target will be 100 pips after entry (taken after the neckline break). More aggressive traders can elect to close half the position once this target is reached and then move the stop losses to break-even for the remainder. More conservative traders should close the entire position once the objective is hit. Profit targets are relatively clear in these trades. Stop losses are not as clear-cut and will actually depend, to some extent on the size of the profit target. For those with a low risk tolerance, stop losses can be placed 10-15 pips above the neckline (for short trades) or 10-15 pips below the neckline (for long trades). For those with a higher risk tolerance (or smaller position sizes), stops can be set above the right shoulder (for short trades) or below it (for long trades). Most important for stop losses, however, is to maintain a favorable risk-to-reward ratio. So, for example, if the profit target is 100 pips, your stop loss should be no more than 50 pips (2:1 risk-to-reward ratio). This also goes far to determine whether or not you should take an aggressive or conservative approach in these trades. Complex Head and Shoulders Last, it should be remembered that with any technical analysis pattern, there will always be some separation between actual practice and the pre-determined ideal. In some cases, the neckline will be flat, others not. Similarly, the number of shoulder can also vary. For example, when multiple left and/or right shoulders appear, the structure would be classified as a Complex Head and Shoulders pattern. In the fifth and sixth charted examples, we can see a sample structure of what this might look like. Two left and right shoulders are accompanied by the head formation before prices push through the neckline. The underlying reasoning behind these patterns is that the initial trend makes a series of highs and low that support the trend. But when this is followed by highs or lows that suggest a turning point, and an eventual violation of the neckline, a Head and Shoulders pattern is in place. This activity can be used to establish contrarian trades. Conclusion: Head and Shoulders Patterns Offer Reliable Reversal Patterns for Contrarian Traders For traders not readily familiar with the Head and Shoulders pattern, the structures should be considered as an added tool in regular trading. These formations make up some of the most reliable reversal patterns that can be found in technical analysis, and they become easy to identify once you begin looking. Added confirmation of pattern validity can gained using indicator readings, violation of Fib support or resistance levels, or price proximity to Moving Averages as a measure of underlying momentum.