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Trading the Head And Shoulders Pattern & Other Chart Patterns

Chart patterns could be an excellent way of trading the markets if they suit your personality and if you are good at identifying them. A great benefit of chart patterns such as rectangles or the head and shoulders pattern is that they provide almost everything you need to have a structured way of trading. They provide an entry price, stop loss level, and take profit level. However, they do not provide rules for money management.  The patterns are straightforward to trade when you understand them, but most patterns have a high failure rate which compensates with a good risk-reward ratio. The combination of low success rate and higher risk-reward ratio has helped me to trade well, yet, this style of trading is not for everyone because of the high failure rate. Also with the introduction of algo traders, and central bankers, and now even presidents, trying to smooth out the volatility of the markets pattern trading has become challenging.

Focusing on Higher Time Frame Patterns

Some traders will trade classic patterns on the smaller time frames such as the four-hour chart, but I have found that they work better on the daily chart, and after they have been given time to mature. The problem with the patterns on the smaller time frames is that news and random market volatility can easily disrupt them. While moves on the daily chart are usually well-motivated by macroeconomic events.

What Chart Patterns I focus on?

There is a large selection of patterns that traders will focus on, but they are not all of the same quality. Usually, patterns that include the break to a trendline such as the triangle pattern will be  less reliable than a chart pattern made up by horizontal levels. That is why I focus on the following patterns:
  • Bullish and bearish Rectangles
  • Descending, and ascending Triangles
  • Bullish and bearish head and shoulders patterns.
Experienced traders will notice that the all ascending and descending triangles carry some sort of trendline, but I will only trade break to the horizontal lines of these patterns. In the rest of the article, I will provide a general overview of the patterns mentioned above.

Rectangle Pattern

The rectangle pattern is probably one of the easiest to spot on any chart and is a combination of several highs around the same level, and lows clustered around a different level. The reason for any market to trade sideways is because buyers and sellers are agreeing on the current price, and after a while, the range of the price becomes more important than the actual drivers of the market. As a hypothetical example, after a few months of little changes in the US and European economy the EURUSD starts to center around a level of 1.20, and every time the price reaches the 1.25 level traders sell and push the price down, while if the price declines to 1.15 traders buy the EURUSD pair. After a few weeks of sideways trading, the European economy starts to deteriorate as per a few economic indicators but the EURUSD remains range-bound between 1.15 and 1.25.  At start traders ignore the economic data, but when the head of the ECB comments on the weak economy suddenly the EURUSD starts to challenge the 1.15 level.  Traders that are long now become nervous and start to close their positions, at the same time bearish traders add to their bearish EUR USD exposure. Eventually, the price slips below 1.15 and starts to trigger stop-loss orders causing the price to close the day at 1.14. Here the price has had a successful breakout, and going forward more people will sell as they are losing money on their positions, and as the price in the EURUSD tries to catch up with the last few week’s negative news. Using the text-box example below of a rectangle pattern, traders would short at 1.14, with stops somewhere inside the pattern. The take profit level is usually derived by taking the difference between the low and high, and in our example, that is 10 big figures, and this is subtracted to the breakout point of 1.15, to derive to a target of 1.05.  Most of the time the price will not decline in a straight line, and it might not even reach 1.05, but if the stop is placed correctly then the risk-reward-ratio will remain good, and compensate for all the times when the market experiences a false breakout.  A false breakout is when the price leaves the rectangle price range, but eventually forces itself back into the prior price range and starts to trade sideways once again. The pattern below also has a bullish version which looks the same, with the exception that the price trades higher instead of lower.

Bearish Rectangle Pattern

Bearish rectangle pattern

Head and Shoulders Pattern

The head and shoulders pattern is probably the most famous of all classic chart patterns. You will usually find it at the end of a bullish trend, or in the case of a downtrend, you might find the inverse head and shoulders pattern.
The pattern seen above is the bearish version and will be found when a trend is about to end. As the market is trending sharply higher the price creates a new higher high (LS) followed by a new higher low. A few weeks or days later the price races up to a new maximum (head), some speculators book profits and the prices decline to the same or similar level and low as after (LS). Bulls try then once again to lift prices, but they don’t manage to overtake the maximum (head), instead, the prices trade lower and trades below the double bottom. As the price just created a new lower low the price is no longer trading upwards, and the price is now bearish so more people pile in on the selling. According to the pattern, the price will now decline by the same distance as the difference between the double bottom and head, as seen in the image below. The double bottoms will not always line up perfectly, but we can connect them with a trend line that we call the “neckline.” A stop-loss order can be placed above the RS high, or just above the neckline. The idea with the latter stop loss is that the trader gets out if the price trades back into the pattern. One benefit of this stop type is that the risk-reward ratio strongly improves, but there is a higher chance that the speculator gets stopped out by a random move.

Ascending Triangle

The ascending triangle is a powerful pattern that I like to trade, but I only trade one side of it, and that is the break to the horizontal line. Some Forex and CFD traders will trade a break to either side of the pattern, but as with any trend line, it depends on the subjectivity of the trader. Some speculators will draw trend lines via the highs or lows of the chart candles, while some will use closing prices, and this means that you will have traders looking at different price levels, and therefore not act at the same time. However, when you draw a horizontal line via three swing lows that are around the same level there will be little guesswork on what level traders are watching, and how buyers will react if the prices slide below the triple low. That is why most traders place a stop below an important low or high, and very few place stop-loss orders below or above a trend line. That means that when the price crosses the trendline of the ascending triangle is nothing that says that you will have a large price reaction that is tradeable. There are different thoughts on what makes up an ascending triangle, but I prefer three highs around the same level and a series of higher lows. The benefit of the trend line is that it allows us to derive a profit target. Some traders will take the base of the pattern, but if you trade the pattern on the daily chart it is unlikely that the price will reach your profit target. Instead, I will take the difference between the trend line and horizontal line at the midpoint of the pattern, and add the difference to the breakout point to derive the profit target. On a daily close, or what looks to be a daily close beyond the horizontal line the pattern suggests that we should buy. Some speculators will place a stop just below the nearest swing low of the pattern, while some will see a decisive correction back into the pattern as a failure of the pattern and exit their trade. The example shown above is the ascending triangle, but there a bearish version of the pattern that is the mirror image of the pattern seen above.

A word of caution

As with any of these patterns, it does not pay to place an entry order too close to the breakout levels, and I have seen some investors enter when the price is well beyond the patterned barrier to ensure that they only trade patterns that have completed. One problem with this strategy is that they will reduce their risk-reward ratio, on the other hand, they will increase the success rate. Don’t miss a beat! Follow us on Twitter, and interact with Alejandro Download our latest quarterly market outlook for our longer-term trade ideas. Do you enjoy reading our updates? Become a member today and access all restricted content. It is free to join.