In the past couple of articles, we looked at some ways on how traders can get an early start into trading an evolving head and shoulders pattern as well as some tips in how to set more achievable targets when trading this commonly found and one of the simplest chart patterns.
You can read more here on the previous two articles.
- Tricks of the trade – The Head and Shoulders pattern, Part 1
- Tricks of the trade – The Head and Shoulders pattern, Part 2
In this final series, we take a look some examples on how you can trade the head and shoulders pattern in real time.
Example 1 (A near textbook example)
The above example shows how you could have traded this pattern. After the neckline support had been formed with prices testing support near the left shoulder, price rallied to make a higher peak (head) and bouncing off to form the right shoulder.
Using, the Fib tool, we first measure the neckline to the head’s high and watch for potential reversal near 61.8% – 78.6% Fib level. When prices reverse here, sell at the market with stops at the high of the head, targeting the neckline, 161.8% Fibonacci extension from the head to the neckline and finally the full measured move (200% level).
Stops are moved to break even after the first target is reached.
Example 2 (A near textbook example)
The second example above shows a smaller version of the head and shoulders pattern. Here the trick is in catching the retracement that formed the right shoulder rather quickly. Price action has been choppy at the 618% – 78.6% reversal level.
Price quickly continued lower on a breakout from the neckline, reaching the first target followed by 1618% and 200% of the Fibonacci extension from the head to the neckline support level.
Example 3 (Missed opportunity)
The above example shows price respecting the structure of the head and shoulders pattern without meeting the guidelines.
This is a missed opportunity, but it shows that the pattern can at times continue to respect the head and shoulders measured move approach without having to meet the guidelines. A trader should exhibit discipline to take the trades that only fulfill the criteria.
Example 4 (Structure is respected)
The next example here shows a head and shoulders pattern that is not quite a neat head and shoulders pattern. At the right shoulder, the reversal is missed as price falls short of rallying to the 61.8% – 78.6% Fibonacci level. Still, despite the breakout from the neckline, price rallies back to the reversal zone before pushing lower. This pattern is a bit tricky to trade, but illustrates how price action can at time respect the structure and the rules. Another interesting bit about this example is the price reversal near 161.8% without reaching the final target.
Example 5 (Patience is key)
In this example, you can see the rather delayed period in the formation of the right shoulder. You will also see that this is not your clean head and shoulders pattern, but the structure is respected well enough to offer a profitable trade set up here. Again, you will see prices bouncing off the 161.8% (target 2) in this setup.
Example 6 (An evolving pattern that was invalidated)
In this example, we have a pattern that is still evolving. We can see the neckline resistance formed with the left shoulder and the head formed. Currently, we wait for the price to fall towards the 61.8% – 78.6% reversal zone (1.3002 – 1.2977) for long positions with targets set to 1.3901, 1.3180 and 1.3235 with stops at 1.2947.
Trading the head and shoulders pattern – Conclusion
In conclusion, the above examples illustrate how traders can simply focus on the head and shoulders pattern and try to catch the setups early on. With proper focus on risk management, this approach to trading can yield significant profits over time. The only downside being that the trader will have to constantly monitor the various securities or assets on an almost daily basis and across different time frames in order to catch the set up while it is still evolving.