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?
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:
- Clear evidence that the market sentiment is bearish
- Signs that segments of the market is leading the bearish move
- Ability to short high
Let’s look at this new picture below.
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.
- A is just a retracement/correction of X so traders are justified think in terms of continuation i.e. higher-low -> higher-high
- X will be treated as a potential support
- No new trend exists
- B beats X so a new trend has started i.e. lower low (green zone becomes bearish expansion)
- X is unlikely to play role as support but could become resistance
- Whereas A makes bulls bolder, B encourages bears
- Any retracement after B (blue arrow) to form a right shoulder will be a deeper Fibonacci retracement compared to that of A (black arrow)
- 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‘