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How to Use Head and Shoulders for Trading in the Forex Market - 360 Degrees Markets Ltd (
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02nd Nov 2020

How to Use Head and Shoulders for Trading in the Forex Market

Article Table of Contents:

The head and shoulder pattern gets its name from its distinct appearance. In this chart formation, there is baseline with 3 peaks, with the one in the middle being the highest (like a head) and the 2 outside peaks being lower than the head but similar in height to each other (like shoulders). Hence, the name. 

The pattern is one of the most popular and reliable technical tools for identifying market reversals. This chart normally represents a trend reversal from bullish to bearish, signalling the end of an upward trend. 

How a Head and Shoulders Pattern Forms

As mentioned above, a head and shoulders pattern has 3 peaks. The left shoulder is formed due to a price rise, ultimately peaking and then declining. This happens when a long bullish trend ultimately subsides, forming a trough. The price then rises to a higher level and declines again, surpassing the previous peak. The price rises for a third time but only reaches levels close to that of the first peak. These formations are rarely perfect, due to the presence of noise.

Trading Forex Using the Head and Shoulders Pattern

First, it is important to correctly place the neckline in a head and shoulders pattern. The neckline is the resistance and support level, used for determining strategic areas for placing orders. To identify the neckline, the first step is to locate the 3 peaks in the chart. Then, the low after the first shoulder is connected with the low created before the right shoulder. This creates the neckline. 

When trading forex using the head and shoulders pattern, traders expect the price action to move below the neckline. After this, it is recommended to measure a profit target by measuring the pattern’s height from the neckline to the peak of the head. Once the pattern completes and the price goes below the neckline, a short position can be taken. 

A similar strategy can also be used in case of an inverse head and shoulder pattern. In both cases, it is prudent to exit the position at the set target. If the price keeps moving in your favour, you could consider holding the position until the development of the next reversal signal. 

Placing Your Stops and Profit Targets

Traditionally, the stop order is placed slightly above the right shoulder, after the penetration of the neckline. You can also use the middle peak of the pattern as the stop. But this carries a much higher risk, impacting the risk to reward ratio. 

The profit target is the difference between the head and the lowest point of either shoulder. The difference is then deducted from the neckline breakout level. This provides a price target to the downside. The neckline breakout level and the difference are added, in case of a market bottom, providing a price target to the upside. 

When using this pattern while trading, patience is key. Some traders start using the head and shoulders pattern before the pattern has completely developed. This can be a mistake, since there is no guarantee that a partially developed pattern will complete itself in the future.