1.- Abstract:

Traders often are excited the moment that saw a pattern like head and shoulder because this can give to us a big profit if is managed property.
But there aren't guarantee that this pattern is 100% effective, this can be because the pattern sometimes is not clear when it comes.
Also, some traders without experience can be in troubles and fall into a bad trade if do not follow the guidelines to approach it.
The main goal of this article is to give traders the tips to catch a clear pattern and avoid those who seems are nice.

2.- Development:

There are tons of information about this pattern, but with my daily research can show to you these small things that could end a bad trade.
This pattern starts to develop when buyers are near or at a point of exhaustion and means that a reversal is coming up soon.
We can identify this and be making a relation with the highs and lows, the trend is changing because price action can not make a new higher high or lower low.

To make it quick, I will make a summary with the bad and good of this pattern.
The theory says that there are few features to know before to trade it, these are:
  • Chart: Is best if we can use the line charts, the pattern can be saw clearly.
  • Time frames: Daily and Weekly. (Big profits)
  • Price action must be on Up Trend, downtrend if we have an inverted pattern.
  • Left and right shoulders complete formed. (NECKLINE)
  • The top of the pattern or bottom if is inverted.
  • To wait for the breakout, a price close below the support or above if is inverted to place market or limits entries.
2.1- The wrong way to trade head and shoulders:

The common mistake to trade this pattern is to enter the trade as soon as the right shoulder forms.
That means traders go short when the price is lined with the price of the left shoulder and can't wait for a close.

Also, another mistake is to get as valid a pattern when the support or NECKLINE is pointing down when is an uptrend.
Or pointing up when is an inverted pattern.

The best is when the support is pointing down in an uptrend and up when price action is a downtrend.

2.2.- The suggested way to trade head and shoulders:

In my opinion, the best way to enter the trade is placing a sell limit few pips below the support (NECKLINE) when we have the technical break.
This approach can give to us more room and less risk if the market makes an unexpected reversal to the upside.

But, if you miss the opportunity when price touch the support and back down you can place the sell stop below the last low.
This can be a conservative but safe approach with less reward.
The chart below, show us and example on weekly GBP/JPY chart.
  • Pattern complete formation
  • Target by nearest zone
  • Target by the level at 161% Fibonacci extension.

2.3.- Stops and Limits:
  • Stops: The proper stop could be set up the price at the last higher high or at the top of the right shoulder. This can be less risky because other says to put the stop at the top of the whole pattern. For me is too much if you are managing an entry of 2 lots or above.
  • Limits: There are few options to take profit of this pattern, and I will give to you there to your consideration.
a) At the nearest zone: this is popular, using pivot points to calculate the next support / resistance areas.
b) At the Fibonacci levels: this is my best, to get profit at 161% or 144% of the extension.
c) At flat fixed: this means that you could measure the pips if the pattern, from the support to the top and this value in pips could be the target.
The chart below is showing us this option. On blue color is the measured distance between the base and top of the pattern.
I am placing the same shape as the flat target to avoid make any calculations.



3.- References:

http://www.investopedia.com/articles/technical/121201.asp

5.- Conclusions:
  • Realy big profits can be made of the head and shoulders pattern.
  • The risk to get into this kind of trades are high but if pass all the characteristics the reward will be great.
  • Avoid to get into a head and shoulder with neckline pointing to the downside if price action is going on the uptrend.
  • Make proper calculation to squeeze all the profit can you make.
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