“Head and Shoulders”
Today we will study a most well-known trend reversal model
called “Head and Shoulders”. During our previous lesson we discussed that
existence of a previous trend is required for formation of every price model.
The condition for formation of the “Head and Shoulders” model is ascending
movement in a price graph, when every next rise and fall is higher than the
previous one. Note that in Figure 1 the trend is even accelerated at a certain
stage of the trend development, which is proved by a sharper inclination angle
of the trend additional line. However, all good ends sooner or later, and we
receive preliminary signals about the trend slowing down, when price pierces
the trend lines, both additional and initial ones.
Fig.1
It is required to note that the trend line breaking does not
inform about a trend moment reversal. It is rather a signal that it is required
to close all buying bargains and not to buy new ones. It is like you have
caught a cold and can recover soon. However, it is necessary to be ready for
the situation getting worse. If the price overcomes the last maximum, it means
that the trend has recovered and the ascending trend has gained its strength
again. However, if the price moves upwards again after the correction
downwards, but sets its maximum below the previous one, in this case we will
receive a weightier signal about the oncoming reversal – Fig. 2.
The next formation is apparent, which resembles the model of
head (the highest maximum) and shoulders (maximum left and right from the
highest one), meanwhile the ratio between the right shoulder and the left
shoulder is not so important. The main point is that the model head should be
apparently higher than the shoulders. If to consider such a situation
logically, the formation of the right shoulder means unfortunate attempt of
bulls to continue the ascending movement. And in this case a popular football saying
can work “If you do not score a goal, a goal is scored to you”.
Fig. 2
By the moment of the right shoulder formation, the price
forms a support which we can mark through the last two minimums – points D and
E, which the model head rests on. Such a line is called the neck line- Fig.3.
And when price breaks through the neck line, we receive a selling signal. In
order not to make haste, it is recommended to look for opportunities to sell
after candle closing below the neck line. At the moment of the signal we
already have conditions for formation of the descending trend, namely two
successive descending maximums – the model head (point B) and its right
shoulder (point C), through which we can draw a trend line. We will draw the
channel line parallel to descending line of the trend through point E, then the
trend line may serve as a guide for the profit fixation - Figure 3.
Fig. 3
In addition, the “classic” method for defining the target is
drawing a vertical line from the head to the neck, set then from the breaking
point - Fig. 4. Now let us remember one more approach to the price models. The
volume should grow when the model is broken through, which proves the true
signal, as the pressure on the price from the bears` side is higher than from
the bulls` side – this is ticked in Fig. 4. It is required to note that the
volume should be considered not as the absolute value, but as a relative one.
But at the same time the volume value should not necessarily be the highest one
for the whole period of the financial asset existence.
Fig. 4
After the price has come below the neck line, we have the so
called “forbidden area” for the price, where it should not rise to. This is the
area above the neck line. In order not to fall for the bait by false signals,
we recommend making conclusions on the basis of the closing price (by the
candle body, without taking shadows into consideration). However, if at closing
the price returns into the model, it is worth thinking over whether it is
required to close the position, since the possibility of a false breakthrough
is high. At the same time, the price returning to the neck line as itself is
quite advantageous, because in this case the market proposes a profitable price
for opening a position with the trend.
There are some other indirect signs of the “Head and
Shoulders” model formation which prove its significance. Firstly, it is
divergence with the price in oscillators when the model head is formed. Note
how the price sets a higher maximum, but MACD histogram sets a lower maximum
against the previous one in Fig. 5. Secondly, the model looks harmonious when
the right shoulder reaches Fibonacci correction level 61.8, the so called “gold
section” – this is ticked. In addition, of course, the time interval, which the
price model is formed in, is of importance. The larger the graph scale, the
more seriously a signal should be treated. The model strength in smaller time
intervals, on the contrary, may be doubtful. In particular, we do not advise to
use price models in a smaller scale than in the hour one. As for the “Head and
Shoulders” model, which there emerges after a down-trend, it is acceptably
called “inverted”. In its core, it is the mirror of the model we have just
discussed. The working rules with it are the same.
Fig. 5
In the conclusion I would like to add that although new
technical devices and new inventions appear both in science and in trading in
particular, human psychology remains like a hundred years ago. Fear and
greediness, hope and euphoria rage in the market. And as price models reflect
mass human psychology which remains unchanged with time, you will get a
powerful tool for analysis and prediction of the situation future development
in any mass financial market, if you apply them properly.
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