Head & Shoulders: a Close-up

By Tradecision Analysis

A Cinderella among the Nobles

Trading methods are not only different and, most of the time, personalized ways of looking at the market or the developments that take place on it. In most cases, they turn into a sort of living entities that have their own histories and lives. Unlike some of the famous methods, shrouded in myths and invented by some celebrated, charismatic, and enigmatic personalities to whom they owe their popularity, the well-known Head & Shoulders method was neither concocted by any controversial trading guru nor is it promoted by the less lucky in trading offspring of the latter, who opted for the marketing of their great grandfather’s dubious legacy having considered the other option of setting up a diners for the local townies round the corner. And this is what gives another reason to look more closely at why the technique is so popular with so many traders.

How It Works, or You Still Need a Head on Those Shoulders

Basically, the head & shoulders technique is rather simple as compared to most other methods. You don’t need to painstakingly select any inputs to train your software, measure the planetary influence of Saturn or count the number of successful UFO landings on it. It’s all pretty much down to earth, and, probably, this is one the method’s major merits: you can clearly see the advantages and disadvantages of what you entrust your hard-earned bucks to.

The Head & Shoulders pattern is comprised of four equally important parts: the left shoulder, the head, the right shoulder and the neckline. The starting point for the formation of the figure on the whole, and the left shoulder in particular, becomes a sharp rise in the trend-line followed by a fall, a downward advance, and the largest volume in the pattern. The peak volume is accounted for by the growing number of buyers, joining in as the upward move continues.

Now we have the left shoulder. The head is formed by an upward and shorter advance toward the highest peak in the formation, a fall, and a peak volume for this part of the figure. The right shoulder starts with a high-volume sell-off and an upward trend. This upward trend breaks lower than the head peak to cause the volume to fall to the lowest point in the pattern as the public starts awakening to the reversal in the making. The main element in the pattern is the neckline, drawn between the lowermost points of the shoulders. The pattern is complete when the neckline, being a support line, is pierced by the right shoulder. The “lifespan” of the pattern is normally from several weeks to several months, and it’s unlikely to be suitable for use over the longer haul. One the face of it, getting the hang of the whole thing is like a cinch: definitely no nerdy background is a requirement. But as a thinking trader you are aware that everything can be so simple only in that software with the one magic button, fools spend their whole lives looking for. Therefore, what are the pitfalls and how to avoid them?

Identifying the Familiar Silhouette

A really big problem about the Head & Shoulders method is that if you really want that to happen, you’ll see signs of the pattern occurring everywhere. A sign of a true occurrence of the pattern is a very sharp rise in the price and a distinctly large volume this rise is accompanied with.

Also, one should always bear it in mind that for this specific pattern volume is of greatest importance. A very low volume on the right shoulder means that a reversal is happening. A true reversal is also accompanied by the price falling far enough below the neck-line. The market tries to overcome the previous high, fails to do so, and, thus, experiences the deepest drop for the entire pattern. Most probably, it is largely this simple, “trustworthy”, and entirely logical explanation that the technique owes the trust many traders put in it to. Please note, that if the price trend-line is simply bobbing along the neckline, you may well expect an upward move.

Another helpful sign is that the peaks of the two shoulders should take roughly the same amount of time to develop and be roughly of the same height.

Overall, one can say that the possibility of error while recognizing the true occurrences of the pattern, especially with novice or less experienced traders, is pretty high. The chances can be approximately estimated as 50/50. That is why, to reduce the related risks, it would be expedient to use this method as an “auxiliary” method along with the other methods you use until you feel more confident about your pattern recognition ability. In any case, another result that coincides with the result of your forecasting results will not do any harm.