Head And Shoulders - The most effective way to trade

The head and shoulders pattern is probably one of the most classic trading patterns in forex investment. However, this model may cause many surprises for new traders. Understanding that, in today's article, we will guide you in detail step by step, as well as how to use this model in the most effective way!

What is the head and shoulders model?

As the model name Shoulder - Head - Shoulder will have 2 shoulders and 1 head with the following 5 attributes:

Uptrend

left shoulder

Head

Right shoulder

Neckline - support line

Thus, the head and shoulders pattern is a reversal pattern that appears at the end of an uptrend, formed by three consecutive peaks. From a distance, they look exactly like a human's torso with one head and two shoulders. In particular, the middle peak is the highest peak, the two sides are two shoulders that can be nearly equal or the left shoulder will be higher than the right shoulder, but must not exceed the head. Take a look at the example below to better understand this model:

Structure of the Head and Shoulder model

Now we will analyze each part of the model's "body" to assemble it into a complete Shoulder-Head-Shoulder structure:

Part 1: Upward trend

The first part of the head and shoulders pattern is an uptrend. This is an expanded form before leading to exhaustion of the buying side, making the price unable to climb anymore. In principle, the longer the uptrend lasts, the greater the probability of a reversal.

Part 2: Left shoulder

The market started falling and formed a higher low (HL). At this point, everything is starting to work together, but it's still not enough to determine the neckline.

Part 3: Head

Now that the left shoulder is formed, start creating a higher peak (HH) to form the head. But despite the rising prices, the bulls could not Create a higher bottom.

At this time, the left shoulder and head were formed. The neckline starts to appear, but requires a right shoulder, before a neckline can be drawn on the chart.

Part 4: Right shoulder

Right shoulder formed when it shows that the buyers are tired and the market may be preparing to start a reverse trend.

As soon as the right shoulder appears, we have enough data to start drawing the neckline. But because the model is not really complete, it's best to think of it as a rough draft rather than the perfect version for you to trade.

Part 5: Neckline

Now that one head and two shoulders have been defined, you can start drawing the neckline. This can also be considered as a complete model, traders will base on this to trade as soon as the collar line is broken.

What caused the head and shoulders pattern to be formed?

Perhaps because buyers are really tired, they are too tired to create higher peaks or higher bottoms to confirm the existing uptrend. Therefore, it is time for a reversal trend to take place.

Thus, the price structure itself has reversed the market. Transition process between buyer and seller. The actual model is only the result of a mirror of that process.

To explain more clearly, look at the shoulder-to-shoulder model from a different perspective. And to clarify the problem we will use GBP JPY as an example.

Looking at the example above, you can see that after creating a higher peak HH (the first part), the buyers continued to test with the expectation that they would push 1 more peak, but they were exhausted. pushed higher and formed the right shoulder.

Creating 1 LH (higher peak) will be a good signal if you plan to Sell at this time. The GBP JPY pair I just gave an example of clearly shows that.

As we all know, according to the market must Price Action to confirm an upward trend must always create higher peaks and higher lows. If creating a lower peak could indicate that the exhausted buyers could not push it higher, it is a good signal for the sellers.

It should be noted that the model must be in the correct order of Shoulder-Head-Shoulder to be effective. If reversed, the model will no longer be true. Because of the combination of higher peaks and higher troughs in the development interaction in an uptrend, a new pattern can form, like a human's head and shoulders. However, for the model to be confirmed, the neckline support is required.

And by breaking the border, especially when the candle is closed below the neckline as illustrated below, confirms the actual head and shoulders pattern is actually formed.

How to input commands for head and shoulders model

There are 2 ways to enter commands with this model you can refer to:

Method 1: As soon as you see the price break below the neckline you can enter a Sell order, which means you will not wait for the price to retest the Neckline but sell it.

This approach can give you a tremendous amount of profit. If the price is on the right track, it could be a false breakout when the price reaches it, but it does not control the trend.

And there is a high possibility that you will make a loss. Therefore, to make sure, many traders will use the second method as follows.

2nd way: You must wait for the price to close at the Daily frame (the day frame) below the neckline. By doing this, you will minimize risks and prevent losses significantly. However, even waiting for the candle to close below the neckline, there are two ways to enter the order.

Option 1: You will immediately Sell or Short when you see the candlestick close below the neckline.

Or plan 2: wait for the price to return, retest the neckline, and turn them into a new resistance, like this:

Using option 2 will bring you the following benefits:

It helps confirm the true price that will be broken

The R: R ratio will be higher than the ways I mentioned earlier.

Option 2 is the form we recommend. However, traders will always be impatient to wait until this moment, which often speculates that the head and shoulders pattern formed is immediately on the order. Of course, this option can make you miss many opportunities, but their ability to wear durable clothes is very high, compared to other options.

How to find a cut-loss point for the head and shoulders pattern

This is what you must do when participating in forex trading, whether you like it or not. Although there is a lot of controversy surrounding the stop loss of the head and shoulders pattern as many traders prefer to stop the loss at the top of the right shoulder, while many others choose a lower, lower position.

I personally think that a stop loss at the top of the right shoulder will bring The risk is very high, not really necessary and adversely affects the R: R ratio you set. Here we will suggest a few other stop loss that you can refer to.

Stop loss according to plan 1: At the point just above the right shoulder.

Note how this stop loss is quite far from the entry point into the order. And as mentioned before, in my personal opinion, this is not a nice stop loss, because stopping a hole too far will reduce your own profit, causing a lot of loss to the trading order.

Stop loss according to the second plan: Stop loss at a position on the swing high (swing high)

This is my favorite stop loss position. Because it gives a nice R: R ratio, that means my risk will be greatly reduced if I use this method.

If you set a stop loss here you will only lose 200 pips instead of 1800 pips as Stop loss plan 1. In general, it depends on the calculation and trading plan of each person, you can set a lower level. However, you should calculate the R: R ratio very reasonable. How can you risk less than 2% of your money?

How to find suitable profit-taking points

Profit taking at the right time is the best way to manage your capital and assets. At the same time, it is also the biggest challenge for traders when participating in forex trading. With the head-to-shoulder model, there are 2 ways to take profit as follows:

How to take profit number 1

This is quite conservative when you set the profit-taking levels at the key support levels. At these prices prices often bounce (bounce) to retest. So it might be a good idea to make a profit when the price backtest here.

Because each different situation will have different levels of support. But one thing you must make sure of is that the R: R ratio must always be from 1: 2 above.

How to take profit 2

The key to taking profit here is The distance is calculated from the neckline to the head. This method is quite popular, applied by many traders, the profit you earn is also more, but honestly not everyone patiently waits until the price gets there.

Note that the point I measure is calculated from the top of the head to the neckline. Then I took the same distance to measure, love from the neck contour area broken down. As I said, few people will be patient enough to wait until the price runs there or the price may never get there. So you can identify important support levels close to the target, and closing orders at those levels will be more feasible. Good luck!

The article has information from dailypriceaction.

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Author: Tin Nguyen