Head and Shoulders
A head
and shoulders pattern is also a trend reversal formation.
It is
formed by a peak (shoulder), followed by a higher peak (head), and then another
lower peak (shoulder). A "neckline" is drawn by connecting the lowest
points of the two troughs. The slope of this line can either be up or down.
Typically, when the slope is down, it produces a more reliable signal.
In this
example, we can easily see the head and shoulders pattern.
The head
is the second peak and is the highest point in the pattern. The two shoulders
also form peaks but do not exceed the height of the head.
With this
formation, we put an entry order below the neckline.
We can
also calculate a target by measuring the high point of the head to the
neckline. This distance is approximately how far the price will move after it
breaks the neckline.
You can
see that once the price goes below the neckline it makes a move that is at
least the size of the distance between the head and the neckline.
We know
you're thinking to yourself, "the price kept moving even after it reached
the target."
And our response is, "DON"T
BE GREEDY!"
Inverse Head and Shoulders
The name
speaks for itself. It is basically a head and shoulders formation, except this
time it's upside down.
A valley
is formed (shoulder), followed by an even lower valley (head), and then another
higher valley (shoulder). These formations occur after extended downward
movements.
Here you
can see that this is just like a head and shoulders pattern, but it's flipped
upside down. With this formation, we would place a long entry order above the
neckline.
Our
target is calculated just like the head and shoulders pattern. Measure the
distance between the head and the neckline, and that is approximately the
distance that the price will move after it breaks the neckline.
You can
see that the price moved up nicely after it broke the neckline.
If your
target is hit, then be happy with your profits. However, there are trade
management techniques where you can lock in some of your profits and still keep
your trade open in case the price continues to move your way.
You will
learn about those later on in the course.
