What are chart patterns?
Chart patterns play an important role in any useful technical analysis and can be a powerful asset for any trader at any level.
We all love patterns and naturally look for them in everything we do in our everyday life, that’s just part of human nature, and using chart patterns is an essential part of trading psychology.
A chart pattern is a shape within a price chart that helps to suggest what prices might do next, based on what they have done in the past. Chart patterns are the basis of technical analysis and require a trader to know exactly what they are looking at, as well as what they are looking for.
There is no ‘best’ chart pattern, because they are all used to highlight different trends in a huge variety of markets. Often, chart patterns are used in candlestick trading, which makes it slightly easier to see the previous opens and closes of the market.
Some patterns are more suited to a volatile market, while others are less so. Some patterns are best used in a bullish market, and others are best used when a market is bearish.
Traders and analysts constantly study trends and patterns when watching the market in hopes of detecting the next probable price movement.
Why are chart patterns so important?
On a very basic level chart patterns are a way of viewing a series of price actions which occur during a stock trading period. It can be over any time frame – monthly, weekly, daily and intra-day.
The great thing about chart patterns is that they tend to repeat themselves repeatedly. This repetition helps to appeal to our human psychology and especially trader psychology.
By learning to recognize patterns early on in trading, you will be able to work out how to profit from breakouts and reversals.
Therefore, it is important to spot and correctly identify patterns, and understand their significance so as to have successful trading as well as using the wrong one or not knowing which one to use may cause you to miss out on an opportunity to profit.
We’ll discuss Head & Shoulder Pattern in detail, as Head & Shoulder is one of the most important because of its longstanding history of reliability among market analysts.
What is Head & Shoulder pattern?
In terms of technical analysis, the head and shoulders pattern is a predicting chart formation that usually indicates a reversal in the trend where the market makes a shift from bullish to bearish, or vice-versa. The Head & Shoulder pattern is believed to be one of the most reliable trend reversal patterns along with entry levels, stop levels, and price targets make its implantation easy. There are two types of Head & Shoulder pattern, one the normal one (bullish to bearish) and another inverse head and shoulder (bearish to bullish).
Basics of Head & Shoulder pattern
There are three main components in this pattern, as the name suggests a left shoulder, a head, and a right shoulder. Other than these three components there are few other basic components which are explained in detail:
- Prior Trend: It is important to establish the existence of a prior uptrend for this to be a reversal pattern because without a prior uptrend there cannot be a Head and Shoulder reversal pattern.
- Left Shoulder: While an uptrend is observed, there is a peak of the current trend and after making this peak the price declines until a trend line and this ensures to complete the formation of the left shoulder.
- Head: From the low of the left shoulder, an advance begins that exceeds the previous high and marks the top of the head. After peaking, the low of the subsequent decline marks the second point of the neckline and the formation of the head is completed.
- Right Shoulder: The advance from the low of the head forms the right shoulder, this peak is lower than the head and usually in line with the high of the left shoulder. The decline from the peak of the right shoulder should break the neckline.
- Neckline: The neckline forms by connecting two points, one being the end of the left shoulder that is also the starting of the head, and another being the end of the head that is also the starting of the right shoulder. The slope of the neckline (slope up, slope down, or horizontal) will affect the pattern’s degree of bearishness i.e. a downward slope will be more bearish than an upward slope.
- Volume: As the pattern formulates, the volume plays an important role in the confirmation. Volume can be measured as an indicator or simply by volume levels. For confirmation volume during the advance of left shoulder should be higher than during the advance of the head. The first warning sign is observed with the decrease in volume and the new high of the head, the second warning sign is observed when volume increases on the decline from the peak of the head, then decreased during the advance of the right shoulder with the final confirmation being observed when volume further increases during the decline of the right shoulder.
Interpreting the pattern
The pattern formation is started with the prior trend being bullish, followed by formation of the left shoulder, then the head and the right shoulder all getting support at the neckline. The pattern is completed once it breaks the neckline support to observe a breakout and the increase in volume is observed. Volume indicators can be used to get the final confirmation.
Once the support is broken, it commonly starts to act as a resistance for further price uptrends and the projected price decline after breaking the support is the same as the distance between the neckline and the head. This price target can be considered as a rough guide along with other factors in consideration as well.
This is the basic reason that Head & Shoulder is favored by traders that it has the ability to help them determine the price target estimates once the pattern is completed along with making it easy for traders to place stop-loss orders.
Using the pattern to trade
The most important part of the pattern is to let the pattern complete itself and plan your trades ahead of time so that you’ll be ready once the neckline is broken.
The pattern can be used to trade in two different ways, one way is to short open when the breakout is observed with price breaking the neckline and short close when the target price is nearing.
Another way is to long open once the price has reached the target price as the trend is again expected to change again after that with the neckline to act as resistance for the price further.
The Inverse Head and Shoulder is similar to standard head and shoulder, but inverted, with the head and shoulders top used to predict reversals in downtrend.
Advantages/Limitations of Head & Shoulder Pattern
Each and everything has its pros and cons, and so does the pattern also. There are few advantages as well as limitations to the pattern, explained below:
- The advantage being that it is easy to identify for more experienced traders while difficult to identify for novice traders
- The pattern has self-defined risk and take profit levels, but the confirmation candle may close far below the neckline resulting in last stop-loss distances which need to be reviewed constantly
- This pattern has the potential to exploit big market movements, but sometime the price may pullback and retest the neckline often confusing the traders
- The pattern can be used in any kind of market with any timeframe making it unique
- The risk-reward ratios are not favorable always in this pattern
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