Forex traders look at a variety of chart formations in order to make profitable trading decisions. One of these is the Head and Shoulders formation. It’s basically one top with two smaller spikes to the left and right.
Head and Shoulders Trading Pattern = Potential Buy and Sell Signals in Forex Trading
Let’s say EUR/USD pair is trading at 1.1 (1.1 dollar per 1 euro). In the beginning, it rises to 1.2, and falls back to 1.1 – That’s the left shoulder. After, it rises all the way to 1.3, only to fall back to 1.1 – Here, the head has been formed. Finally, it rises again to 1.2 and falls to 1.1 once again – A right shoulder has been formed.
Traders consider this to be a bearish indicator. The top price (1.3) hasn’t kept up when the second shoulder formed – It indicates weakness. Many traders, once they see Head/Shoulders developing, will sell when the price seems to be coming off the top of the head, or once it reaches the top of the right shoulder. (Selling of the top off the head can be risky as the entire formation didn’t finish yet.)
Often, falling Relative Strength Index (RSI), or a a price falling below the moving average, is used in a combination with Head and Shoulders. In this case, two factors (coming of the top and weakening RSI/moving average) give signals to make a bearish trade.
If the neckline (1.1) is broken, this may be an even stronger signal to sell.
There’s also an inverse Head and Shoulders formation. Let’s say EUR/USD pair is trading at 1.1. The price falls to 1.05 (left inverse shoulder), then reverses back to 1.1, and subsequently falls to 1.0 (inverse head). Then it recovers to 1.1, falls again to 1.05 (right inverse shoulder), and finally recovers one more time to 1.1.
Many amateur Forex traders will think it’s bearish. But, the second bottom (the head) was followed by a right shoulder which is actually higher than the head. It shows some strength.
In that case, traders will also look for a confirmation in the form of a rising RSI or a price going above a moving average. Once the price breaks above the neckline, that could be a buy signal.
Very few of these formations are perfect. Yet, the head and two shoulders is one of the clearer chart formations. There are occasions when the head is almost at the same price level as the shoulders.
In that situation it looks more like a triple head. On the upside, the three tops form resistance points, a price level the currency has trouble surpassing. By the same token, three bottom heads form support points, a price level at which the currency stops falling.
How To Place Stop Loss and Limit Orders?
When trading Forex, it is crucial to place stop loss and limit orders to protect the account. If a trader believes that after the second shoulder the price will come down, and bets on it, then a stop slightly above the price level of a second shoulder should be placed.
For a bet on the upside, when a trader thinks that after a second inverse shoulder the price will rise, then a stop should be placed slightly below the price level of the bottom of that shoulder.
At times, traders see this formation while it’s not really there. It’s important to wait until it forms before taking further action.
Another thing is that this formation may be happening in the long-term (seen on daily charts), but the traders looking at short-term charts (such as one-minute) will not see it. Such traders may not even be affected by it. So, while long-term traders see a bearish pattern, in the short-term there could a spike to the upside.
What’s important is to see the trends and have entry and exit points in a trade. Forex traders need to estimate how many pips can be taken from a formation and what risk they’re willing to take (stop levels).
Stop levels can’t be too wide as this will lead to large losses. On the other hand, narrow stops will lead to trades being closed too early. Also, not every Heads and Shoulders formation will work. But traders can afford to be wrong sometimes, even 50% of the time, if their risk/reward ratio is good. For example, a 3-to-1 risk/reward ratio means that traders estimate the gains to be three time larger than losses. Even when being half of the time wrong, traders can make profits.
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