In our last lesson we learned how to spot a head and shoulders pattern and a reverse head and shoulders pattern in the forex, futures, and stock markets. In this lesson we are going to look at a specific strategy that many traders use to trade these patterns.
Upon the break of the neckline support level the chart pattern is said to be in place so this is where traders will commonly look to enter a short position. Their target will be calculated by measuring the distance from the head of the pattern down to the neckline and then projecting that distance downward from the breakpoint of the neckline. The stop will then be placed just above the right hand shoulder of the pattern which is considered resistance. The idea here is that once the neckline support has been broken sellers will theoretically remain in control but if this does not happen then you are protected with a stop loss just above the nearest resistance level.
Example of the Head and Shoulders Strategy:
For the reverse head and shoulders the strategy is a mirror image of the above. Upon the break of the neckline resistance the pattern is said to be in place so traders will commonly look to buy at this level. Just as with the head and shoulders their target will be calculated by measuring the distance between the head and the neckline but in this case the target is projected upward from the break point of the neckline. The stop will then be placed just above the right had shoulder of the pattern which is in this case considered the nearest support level.
Example of the Reverse Head and Shoulders Strategy:
For confirmation, traders will commonly look for a downward sloping neckline before entering a trade on the break of a head and shoulders pattern and an upward sloping neckline before entering a trade on the reverse head and shoulders, as this is further indication that the trend is reversing. Secondly traders like to see the volume on the second peak (trough with a reverse head and shoulders) be lower than the volume on the first, and the volume on the third peak (trough in a reverse head and shoulders) be lower than the volume on the second peak as this is further confirmation that the trend is ready to reverse. Lastly they will look for increasing volume on the break of the neckline to show that the break is real.
That’s our lesson for today. You should now have a good understanding of the head and shoulders pattern and the reverse head and shoulders pattern as well as a trading strategy for each of them. In our next lesson we are going to finish up on reversal patterns by looking at the rising wedge and falling wedge patterns and then we will move onto continuation patterns after that.
