A chart pattern I see may transform into another: what should I do?
A head and shoulders chart pattern in GBPJPY is changing: how do I apply trading rules?
Daniel, a member of our community asked these questions:
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.
Chart pattern trading rules
To answer Daniel, I have prepared some charts but before that, let’s recall some principles we need to apply when we deal with chart patterns:
- Chart patterns are highly documented, highly recurring price phenomenon that comes with their own trading manual (see ‘Signs that give away a better head and shoulders pattern‘)
- When we deal with chart patterns, we have high probability outcomes but not certainty
- Head and shoulders patterns are high probability reversal patterns
- Their most important features are the head and the neckline. The head is the highest price printed by the pattern. It becomes a resistance level. The neckline is the horizontal (sometimes slanting trend line) level at the low of the two ‘armpits’ – price valleys between the shoulders and the head. The neckline is a support level.
- The more recognisable chart patterns are, the more significant their outcomes.
To discuss further, I also prepared this chart and simplified slightly the picture of the currency pair GBPJPY. GBPJPY prints a big head and shoulders chart pattern (red dotted lines). The potential right shoulder itself also prints a small head and shoulders pattern (blue dotted lines).
Question #1 – What kind of move from GBPJPY will make the head and shoulders chart pattern NO LONGER valid?
A. If price now moves below the neckline, the entire head and shoulders pattern fulfils its function as a predictor of bearish reversal.
B. If price moves above the Right Shoulder / Small Head i.e. the highest point of the blue dotted lines, the smaller head and shoulders pattern is no long valid. However, the big pattern based on the red dotted lines are still valid except potentially losing its symmetry.
C. If price moves above the head (highest point based on the red dotted lines), the entire head and shoulders chart pattern is no longer valid. Price penetrating the highest point is a signal that this formation is a continuation pattern with price following higher.
Question #2 – What if price continues sideways but never trigger conditions A, B and C above?
Then there is a strong possibility that the existing pattern will evolve and emerge as something different. When that happens, Trading Rule #5 has to be applied. Apply rules to whatever new pattern emerges. Below are some examples.
Important: Patterns can change, new rules applies.