In technical analysis the variety of figures and prices can form a chart. Such figures are called patterns or formations. Patterns are great indicators of the consecutive price action forecast, hence traders use chart pattern analysis to increase the profit ratio of their account.
To understand the chart pattern formation, one should know the basics of the price action based on the Elliott Waves principles. The principle of Elliott Waves stands for an 8-wave move of an asset price during its cycle. Each cycle consists of 5 motive (impulse) waves and 3 corrective waves. Each smaller cycle within each larger cycle of a motive wave contains the same 8-wave move.
These combinations of motive and corrective waves create various chart patterns, such as Head and Shoulders and an Inverted Head and Shoulders pattern.
The main misconception of a Head and Shoulders pattern is that it’s a trend reversal pattern. Head and shoulders might be a trend reversal pattern for the shorter cycle of the main motive wave, however as a general rule the completion of Head and Shoulders pattern refers to the completion of the correction, whereas trend continuation is expected.
What are the main attributes of the Head and Shoulders pattern?
The main attributes of the Head and Shoulders pattern are:
Head, which is the current highest level.
Left Shoulder which is a previous peak, always lower than the high, might be lower than the Right shoulder.
Right Shoulder which is the peak following the Head, always lower than the high, might be lower than the Left shoulder.
Neckline, support line which connects the lowest point of the Left Shoulder and the Lowest point of the Head prior to the Right Shoulder formation.
The Neckline is the part traders look for to open their respective trade with this pattern. The neckline represents a static or dynamic support which connects shoulders and the head.
To trade the Head and Shoulders pattern, a trader has to wait for a confirmation of a breakout of the price from the support i.e. Neckline. As a general rule, the price upon breaking the Neckline is expected to go below the support the same distance as the distance from the top of the Head to the Neckline. However, to hedge your risks and maximize profits, it is important to consider previous support and resistance zones.
The best strategy would be to measure a distance from the Head to the Neck and apply it to the highest shoulder.
Similarly the Inverted Head and Shoulders identify the correction though in the opposite to the Head and Shoulders direction. Inverted Head and Shoulders pattern is usually spotted on the downtrend. However, both patterns spotted on the same cycle may refer to a trend reversal as they signal the end of the correction.
In a regular Head and Shoulders pattern, the smaller shoulder represents the weakness of buyers to push the price higher, whereas sellers take control of the market and bring the price down, hence it is considered that the smaller right shoulder signals the strong downtrend pace.
In an Inverted Head and Shoulders pattern, the smaller right shoulder represents the strength of buyers, and the weakness of sellers willing to bring the price lower. Hence it is considered that the smaller right shoulder signals the strong uptrend pace.
One of the most noticeable Head and Shoulders patterns in question remains for Bitcoin. So far the Neckline was able to withstand seller’s attacks, however things might change if this support is broken.
It is always advised to apply risk management and risk/reward ratio when trading these patterns. As a general rule, a trader should place the Stop Loss 10 pips below the Right Shoulder, whereas an entry point should be at Neckline. Place your Take Profit accordingly, based on the distance calculation. Best to use these patterns with oscillators and indicators, for example: RSI, MACD, Momentum, Williams R%. Train your knowledge on Overbit’s demo account to firm your trading skills.