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Signs that give away a better head and shoulders pattern

Great result from our quiz last week

There were 20 responses to our quiz last week ‘Which is better head and shoulders pattern? Why?‘ out of which 17 provided the correct answer. This is a very encouraging result. I admit that being able to answer a technical analysis quiz correctly is not a guarantee that one can make money from trading. But it certainly is the basis for informed thoughtful trading that will lead to consistent outcomes later for each individual. Not a kind of random outcome in the market based on guts and gut feeling.

 

Good head and shoulders patterns provide more clues

Head and shoulders chart patterns are characterised by 3 peaks or inverted ‘V’s. The one in the centre is the highest and forms the ‘head’. The other two make ‘shoulders’. Put together, the pattern prints a high probability bearish reversal setup that is easy to discover by visual inspection in any price chart. There are very comprehensive rules that describe how this pattern should be traded but I would like to add more today.

In most illustrations, head and shoulders patterns are highly symmetrical so that the left and right halves are almost identical. Since perfectly shaped chart patterns do not occur all the time in the real market, some patterns become necessarily better than others. So is a pattern which a higher ‘right armpit’ better at telling bearish reversal or is one with a lower ‘right armpit’ better?

Picture of head and shoulders chart pattern

A: higher right armpit | B: lower right armpit

 

Based on concepts of Dow Theory and Fibonacci ratios

A good head and shoulders pattern should tell a story about price action. There are very strong reasons why traders should be looking out for B. Since we want the head and shoulders pattern to lead to a bearish reversal i.e. start of a new down trend, we want to have:

  1. Clear evidence that the market sentiment is bearish
  2. Signs that segments of the market is leading the bearish move
  3. Ability to short high

Let’s look at this new picture below.

Illustrated picture of head and shoulders chart pattern

B = lower right armpit = lower-low = start of new trend

 

B is superior to A in terms of predicting a bearish expansion because it is a lower-low

A lower-low is a giveaway to a better head and shoulders pattern based on Dow Theory. It starts a new trend and leads to a bigger extension.

  1. A is just a retracement/correction of X so traders are justified think in terms of continuation i.e. higher-low -> higher-high
  2. X will be treated as a potential support
  3. No new trend exists
  4. B beats X so a new trend has started i.e. lower low (green zone becomes bearish expansion)
  5. X is unlikely to play role as support but could become resistance
  6. Whereas A makes bulls bolder, B encourages bears
  7. Any retracement after B (blue arrow) to form a right shoulder will be a deeper Fibonacci retracement compared to that of A (black arrow)
  8. Deeper fibonacci retracement from B lends more energy to make a greater price extension after the right shoulder is completed (red dotted arrow) -> also see article ‘Market psychology at important fibonacci retracement levels

Director, TerraSeeds Market Technician Pte Ltd. Trader, investor. @sohtionghum was picked ‘Top 70 Forex Twitter in 2015’. Operates multiple strategies.

“Dear reader, I do not have a financial license to give advice. I do not know you the reader. Your financial objective and risk tolerance may be different from mine. I am not responsible for any consequence of your action.

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7 thoughts on “Signs that give away a better head and shoulders pattern”

  1. Daniel Ku Guet Liang says:

    Hi Tiong Hum. 1 question: in the case of B, if price shld retrace up & break above X (ie Support become resistance), wouldnt that become WR? Is it essential that the retracement from B must not exceed X? Thanks for your thought in advance.

    1. Soh Tiong Hum says:

      1. WR? Not necessarily. WR depends on how much distance between B &X and the psychology behind i.e. regret. 2. B must retrace as high as possible but not exceeding the head.

  2. Daniel Ku Guet Liang says:

    I attempted to apply the above concept on this pair that I figure is fairly similar to the concept that you generously shared. I am guessing the key that it could be HS i/o WR is the retracement level after B. Wonder if I got that correct? Appreciate your input. Thanks again.
    http://pinterest.com/pin/403987029044571068/

  3. Soh Tiong Hum says:

    Oh this is so wonderful that you have made use of pinterest. I am not entirely certain I got your question -> the lower B goes below X -> the greater the fib retracement it makes when it goes above -> the greater the expansion following.

    1. Daniel Ku Guet Liang says:

      May I squeeze a bit more knowledge from you pls? I attempting to apply what I’m learning here to the GBPJPY chart. In the enclosed chart, the right armpit is lower than the left armpit. It is now retracing up past F6, testing F8, if it falls down we expect greater expansion, is my understanding correct? If price continues upward past the height of the head in this small HS setup, the entire HS including the bigger HS setup is no more head&shoulder formation, am I right to assume that? Thanks in advance for your sharing.
      http://pinterest.com/pin/403987029044641418/

      1. Soh Tiong Hum says:

        Re: GBPJPY head and shoulders chart pattern
         
        1. Expect greater expansion? – Yes
        2. The right shoulder itself is also a head and shoulders. If price moves > the small head – this small head and shoulders formation fails. But the big one is still valid.
         
        BUT if it starts to resemble a triangle, or may be a channel, then some judgement is required. The new formation must be given more emphasis because it is more recent. However it also depends on whether new formation is obvious significant.
         
        Give me some time to think about how many variations can happen for this one – then I will try to illustrate it.

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