Commander in Pips: Let’s shift to another classical pattern that is called “Head and Shoulders” – a very poetical name. This is also a reversal pattern that could appear on any time frame, but most significantly if we see it on the daily, weekly or monthly time frames. Although this pattern has been known since the 1920s and has very constant in shape through time, it is much harder trade it successfully nowadays due to its ultra well-known status.
Pipruit: And why is it called that?
Commander in Pips: This pattern consists of three tops – first and third tops are lower that the second, so it looks like two shoulders with a head between them. Also the reverse pattern exists – “Reverse Head and Shoulders”, that appears on bottoms. We will call it with short name as H&S and study it like we did the Double Top/bottom pattern – first describe it, then show classical approach to trading, points of recognition of a failure and most of the time will be dedicated to the modern approach to trading process of this pattern. We will skip market mechanics, because it almost the same as with the Double Top/Bottom pattern.
H&S pattern is more complex than the Double Top/Bottom pattern, since there are more swings involved in it. Very often it could be difficult to recognize it until the confirmation point. Take a look at chart #1, so as you will find it easier to understand what we are talking about. This is a good example of a Reverse H&S pattern:
Chart #1 | JPY/USD Futures Weekly. Reverse Head & Shoulders patternHere you can see why it is called Head and Shoulders – I adde simple lines so that you can easily see shoulders and the head of this pattern. We would like to see Reverse H&S pattern at bottoms and normal H&S at tops. Also H&S pattern could include other patterns, such as Fib extensions, Gartley Butterflies, AB=CD, “222”, 3-Drives (these patterns we will study in later parts of Forex Military School), Double Tops/bottoms and others. For instance, look at the left shoulder – this is an excellent example of a Failed Double Bottom pattern – see market has taken out the lows of W-bottom and accelerated to the downside.
Chart #1 | JPY/USD Futures Weekly. Reverse Head & Shoulders patternRefresh in memory what we’ve talked about trading of failed W-bottoms in previous chapter – and here you can see how it could be in reality. H&S has almost the same classical approach to confirmation and failing points. But the difference to Double Top/bottom is that it has not just one low/high between tops/bottoms but two, because H&S has three tops/bottoms. That’s why the neck line of H&S almost all the time is not horizontal (like we have here still) but has some slope angle. The pattern treated as confirmed if the market breaks the neckline and shows close above it for Reverse H&S and below it for just H&S.
The pattern is treated as failed if he market shows close beyond the Head’s extreme. In our case it should show a close below the Head’s low.
Some features of H&S that are preferable to see:
1. The harmony in H&S pattern has huge importance. This harmony should be not only in price swings but in time also:
- It is preferable if Head is a 1.618 or 1.272 Fib extension of shoulders, and the height of shoulders is almost equal;
- It is preferable that time of shoulders forming is the same for both of them. In our example we can see, that right shoulder is formed a bit longer. If both shoulders form during almost the same time – much better;
2. Normal retracement of right shoulder to the head is 0.618-0.786, so as left shoulder. If right shoulder shows only, say, 0.382 - 0.5 retracement – it tells that bearish power is strong and H&S pattern is more significant. The same is for Reverse H&S – shallow retracement of right shoulder to head tells about bull’s strength.
3. It is preferable that the neckline has downward slope with H&S and upward slope with Reverse H&S. Although it could be horizon as with our example.
Let’s check our pattern then:
Chart #2 | JPY/USD Futures Weekly. Reverse Head & Shoulders pattern
Pipruit: Well, Commander, I see that our example is perfect in all aspects, except just one – shoulders forming time…
But I have to warn you that you hardly ever will see absolutely perfect example of H&S pattern during your trading experience. As a rule, H&S pattern has some lacks and I have to say that our example is very close to the perfect shape.
Pipruit: So, does it mean that sometimes I will not be able even recognize it?
Trading of H&S Pattern
The classic approach to trading a H&S pattern suggests that we should enter when the market breaks through the neckline. Stop could be placed in two ways – conservative – right beyond the head, according to failure rule, or just above/below right shoulder. The second way seems more logical, because, if market has shown breakout through neckline and a confirmed H&S pattern returns right back and moves above/below the right shoulder, then this fact already tells that something is wrong. Stop placing beyond the head seems very conservative, besides, this puts under question the attractiveness of such a trade, depending on the profit objective.
Now about the target – the classical approach suggests that the target of H&S is the distance from he neckline that equals the distance between the head and neckline. Look at chart #3 – here you can see all the classic issues. By the way – the retracement of shoulders is almost perfect 0.618 one from the head swing.
Chart #3 | JPY/USD Futures Weekly. Reverse Head & Shoulders patternIt’s not forbidden to trade H&S and Reverse H&S pattern in classic manner, but I have to warn you that you will meet with multiple cases when one or another rule will not hold. First of all, it is subject to targets of the pattern and a higher degree of nervousness at neckline breakout point - almost the same stuff as with Double Top/Bottom pattern. And here I want to ask you – what for we will have to suffer it?
Advanced talks on H&S Trading
First of all, I would like to start with profit objective points. In fact, such kind of targets as classical one, and 1.618 Fib extension from ABC pattern, where A stands for head, B – for high between head and right shoulder and C – for right shoulder treated as “extended” and I can even say as “extreme” targets. Although sometimes, the market could reach it and even exceed it – there is no high probability of that. Possibly it could happen in 15-20% of cases. Our task here is to make profit and not to catch huge moves. So, my preferable targets for trading H&S pattern as follows:
Chart #4 | JPY/USD Futures Weekly. Reverse Head & Shoulders patternEven here, you can see, that market has not reached the 1.618 extension target so as classical target (that is even higher), despite the fact that the Reverse H&S pattern was near to perfect. That’s why if you use as a target Fib extension that based on head and right shoulder I prefer to use 1.0 extension or 1.272 as maximum. Odds that the market should reach these particular levels is significant. So, you can see it here.
Also, this is very often happens that around 1.0-1.272 extension targets stand as Fib resistance levels from a previous market swing in opposite direction (in our case down), and they could create Agreements and Confluence resistance areas that the market could not pass through. This is a bit of a delicate topic to cover it here, but just remember that using 1.0-1.272 extension when trading H&S pattern is reasonable.
The second way to estimate target is to use an extension from total Head swing down. Look on the chart #4, this is 1.27 level (red horizon line) and 1.618 level (black line). Although the market has hit them both – better to use 1.27 extension. Anyway, now we will discuss how to trade the H&S pattern, and you will see that after some moment you can choose even an extended target without increasing your risk. All that you will have to do – is to move your stop loss higher.
When we trading H&S our task (besides to make a profit, of course) is to not get in a trap of market makers. As you might have guessed already – the public mostly enters the market after classical confirmation of this pattern. And the classical approach tells, that if market returns right back (below neckline in our case) – this is not good. The public places stops in different places, even from the other side of neckline after confirmation. If just above neckline of Reverse H&S pattern, a strong Confluence resistance stands – it could lead to Reverse H&S failure. So, our task is to be calm and in a profitable position prior to breakout.
Here is how we could do that.
Take a look at chart#5. We assume that we do not foresee the appearance of Reverse H&S pattern right till the low of the right shoulder. Our first look at the market was somewhere in the beginning of 2002. Here we will apply some rules that we’ve discussed in our Forex Military School already.
First, you see that market has shown a Double Bottom failure pattern and accelerates from the 0.618 Fib extension to the 1.0 extension and even lower – without any respect to these targets. It tells that bears control the market and that the market should reach at least the 1.618 extension of ABC-top pattern.
So, that has happened. Then you see the appearance of Bullish Engulfing pattern right at 1.618 Fib extension target. But this was not enough for you to enter into a Long position; you needed some additional confirmation of bullish bias. Also you see side-by-side inside days here, when the followed trading period range totally lays inside the range of previous one. And that has happening during 4 consecutive periods. It tells you that market is building energy and we should be aware of a strong move in one or the other direction sooner rather than later. You prefer to see upside move. That has happened - after couple of weeks (this is weekly chart) you’ve seen that the engulfing pattern has held and the market has shown a strong thrust bar to the upside. On this bar two important things have happened – engulfing pattern has been confirmed and trend has turned bullish. So, now you have solid context to enter Long. But, as we know, we need to buy pullbacks in a bull trend and not just jump into the market. Since, the previous sell-off was strong and this was just the initial pullback, hence the market still has strong downward momentum and first retracement down should be deep. That’s why you have chosen as entry level not 0.382 but 0.618 Fib support from this initial thrust move up.
You’ve entered long right from 0.76-0.7610 area (0.618 Fib support), market even reached 0.786 level, and place stop below the lows of bullish engulfing pattern. Also you have seen that the bull trend holds during retracement.
Chart #5 | JPY/USD Futures Weekly. Reverse Head & Shoulders patternYour stop placement area is absolutely reasonable, because if the market will break it, then it will cancel the bullish engulfing, and it is very probable that the trend will shift bearish again. And now take a look – how tight this stop is, compared to the classical approach. Here is how we get an excellent position even before any suspicions about a potential reverse H&S pattern have appeared.
In general, if the market turns to forming H&S, it will act somehow in this way. Understand what you should watch for. First – some targets around the head. It could be an extension target, as it is in our case, it could be Butterfly pattern target or something. Second – around the head usually appears momentum shifting signs – acceleration of the market in opposite direction and some reversal patterns (candlestick, for instance), trend shifting, or the head even could be in a way of W-bottom. Also remember, that retracement will be deep in most cases due to the preceding strong opposite move. So, don’t be hasty to jump in, very probably the market will hit at least 0.5-0.618 retracement area.
So, our first task has accomplished we have profitable position before the neckline breakout moment. But know you even do not suppose of reverse H&S. The followed move is just a thrust up for you. The next important moment is in August 2002, when the trend turns bearish. This is a time to close half of your position and move your stop on other half to breakeven. Here you start to suspect appearing of reverse H&S. But here you at a huge advantage compares to public. You’re absolutely flat to breakout process and don’t care about it. You’ve already made significant profit and potentially could make even more, if the Reverse H&S will materialize.
Later, in 2003, when market has reestablished the up move and come closer and closer to recent highs you start to see the Reverse H&S pattern. Here you have to move your stop loss to just below right shoulder around 0.80. So, you lock second half of your position in profit and do not feel nervous about the further price action.
Now let’s take a look at chart #4. Even if you have closed the second half at nearest 1.27 level – you are absolutely happy. If you’ve caught some extension from the ABC pattern or even the 1.618 target from head swing – much better.
Pipruit: Commander, but this is rearview example. It’s much easier to talk about it that in reality.
Commander in Pips: This is one to talk! Sure it is. But I have to explain somehow important moments to you, right? If we assume that after your initial entry the market has erased the engulfing pattern and moved down – you’re in loss, that’s obvious. But this loss is very small, compared to the classical approach. Besides, I just want to show you what you want to watch for and how to manage position during H&S development. Applying this knowledge will allow you to have a position that is quite different from the public one. You will not be nervous during breakout and your stop loss will be in a quite a different place.
Pipruit: You’re right with that, Sir.
Commander in Pips: Ok, the last moment is if market shows a H&S failure and moves beyond the head extreme. In this case it is better to act aggressively, because, as we’ve said once failure patterns are even more powerful than direct patterns. They lead the public to panic and people do not know what to do with a failure pattern. Treat it as different pattern and act. You may wait for instance, for the nearest retracement after breakout of head level and enter. Trading of a failed pattern allows you to place a tight stop, because after the real failing, the market usually shows strong moves. Just look at left shoulder in our example – this is Double Bottom failure. Market has fell like a stone after that.
So, here are some small conclusions:
1. Search for some targets around the potential head area;
2. Look for reversal candlestick or classical patterns there. They could appear on lower time frames, by the way, especially classical patterns, because they need more time to materialize than candlesticks one;
3. Wait when the trend shifts there and the market will show some acceleration, momentum changing;
4. Retracement after initial pullback will be deep – don’t hasten to jump in;
5. Enter on this retracement with stop beyond extremes of a potential head;
6. Manage the position as we’ve described. You may close half of your position even earlier and move your stop to breakeven;
7. If just above/below neckline of a Reverse H/S or H/S pattern stands Fib Confluence resistance/support level – then close most part of your position there. Such combination very often leads to pattern failure, or deep pullback.
This is very complicated material, you can’t catch it totally without practice, but applying it – you will better and better understand its advantages.
Pipruit: Thanks, Sir. I’m not finished yet with Double Tops/Bottoms, but here I suspect I will need even more time.