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Using the Head and Shoulders Pattern to Spot Reversals

The head and shoulders pattern is one of the most popular reversal patterns, and there is virtually no trader out there who doesn’t know what the pattern looks like. If the head and shoulders is a reversal pattern, it means that it forms at the end of a trend, whether a bullish or a bearish one. In this area in the Forex Trading Academy project we’re building here, we’re going to cover one more reversal pattern, the wedge. Compared with the head and shoulders pattern, a wedge appears more often, but, from an importance point of view, I would say both rate equally. From an Elliott Waves point of view, the head and shoulders pattern is associated with triangular formations. However, not all triangles look like a head and shoulders pattern, but only triangles considered to be of a “special type”, like the c–e and a–e ones. We know by now that a triangle moves between the b–d and a–c trend lines, but when it is not possible to draw the a–c trend line , then the triangle falls into the “special type” category. This is the point at which when Elliott Waves traders should start looking for a head and shoulders pattern.

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What Makes a Head and Shoulders Pattern?

The head and shoulders pattern is made of three elements:

The Measured Move

Use the Head and Shoulders Pattern to Spot Reversals - 1Besides the elements mentioned above, there is a measured move that comes with the head and shoulders pattern. Such a measured move is the distance from the end of the head to the neckline, projected from the neckline. The measured move is only used to confirm the head and shoulders pattern, though. Because the overall pattern is a reversal one, the new trend that might start with the head and shoulders should be quite powerful, and important in the overall picture. The image on the right illustrates how a head and shoulders pattern looks in theory, and there is a reason why the pattern is not horizontal, but leaning towards the left side with a small upper angle on the right. The reason is that in the Forex market at least, the pattern is  rarely horizontal. Because of the 24/5 nature of the Forex market, look out for these patterns, which can be ugly, inconsistent, and difficult to spot. Moreover, the measured move can be used to find a proper risk/reward ratio. Such a ratio should be at least 1:2.5, and this implies that the measured move should be projected two and a half times to find the right take profit. This is important as otherwise, without a proper risk/reward ratio and other money management tools, it is difficult to be successful with Forex trading.

Retesting the Neckline

There is a saying that the neckline must be retested after it is broken, but this is not a mandatory thing to look for. As a matter of fact, if the measured move has already reached 61.8% of the whole distance to be travelled, and the neckline is not retested, then the whole pattern was probably misinterpreted, and there was no head and shoulders pattern in the first place. If the previous image in this article showed you how the head and shoulders pattern looks in theory, the reality is totally different. The chart below represents an inverted head and shoulders (this means it is formed at the end of a bearish trend) formed on the daily EUR/USD chart, and it depicts the pattern as it is most likely to be found on the Forex market: ugly, difficult to see, and ultimately rewarding.
Use the Head and Shoulders Pattern to Spot Reversals - 2
The head of the pattern is aggressive both on the downside and the upside move, the neckline is not horizontal (as a matter of fact, you will rarely see a head and shoulders pattern on the Forex market that has a horizontal neckline), and it is retested twice. The retest of the neckline comes with almost 2 weeks of consolidation, and this is enough time to spot the pattern and to position accordingly for the move to come. The risk/reward ratio is mandatory, and the classical 2.5 r/r ratio is reached without any problem. The measured move acts here as the base for projecting the risk/reward ratio, and such a ratio should be used every time a trade is opened. In doing that, the trader is disciplined and has a trading plan, which allows for only one winning trade with every 2.5 trades to be enough to stay in the market and not lose money. In the example above, the neckline was retested, but again, this is not a mandatory thing to look for. Sometimes traders stubbornly look for the retest, and in doing so they end up on the wrong side of the market.

The head and shoulders pattern works very nicely with the Elliott Waves theory. Because of its association with triangular formations, it means that the pattern that ended with a head and shoulders is a complex correction. If you look at the articles dedicated to complex corrections here on the Forex Trading Academy, you’ll find out that complex corrections end most of the time with a triangle. Moreover, they will give us a clue regarding the move to follow, whether it is impulsive or corrective, and will have a target for it as well. What I’m trying to say here is that things have a way of correlating with each other, and understanding and applying all the things that make up the Forex Trading Academy articles will lead to successful trading. The only way to survive the Forex market’s aggressive  swings is to be flexible, and correlate different trading theories and patterns.

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