How you should be using head & shoulders price action correctly. Nope, its not about the popular shampoo brand, instead it is the widely know head & shoulders price action. Despite its popularity among traders, unfortunately many misunderstood it and thus using it the wrong way. As a result, many traders lost a lot of money when trading on this specific price action. Today I am going to address this misunderstanding and also share some important criteria of this price action so you can master it.
What is a head & shoulders?
It is a very powerful trend reversal price action. Many traders use it to identify the transition from an uptrend to a downtrend. Before we go hunting for it in the charts, let us understand the elements of it.
As the name suggests, this price action consists of a head, two shoulders and a neckline. And this point onward, many traders already made the first mistake, which is completely ignoring the neckline. Unfortunately this is because many inexperienced traders are overexcited when this pattern is the process of forming that they completely ignore the neckline and shorted the market too early (at highlighted POINT A below). Subsequently the market shot up to the sky and traders lost their pants and money.
Do you noticed that when the prices is currently trading at POINT A, does it look like the market is just having a small retracement in an uptrend? And when prices subsequently trading higher from POINT A, does it look like an even clearer uptrend? Due to impatience, many traders lost a lot of money trading this pattern. Unfortunately, this is how smart monies make money from impatient traders. A good rule of thumb is to wait for prices to break below the neckline before shorting the market.
Yes, you are correct that you will missed a few extra points by waiting for the break of neckline. However, what you gain in return is a high probability setup.
Another thing to keep in mind is that no head & shoulders pattern is form prefect symmetrically. As long as you can easily identify clear head, 2 shoulders and a neckline, that should be enough for you.
Context & where head & shoulders should be found?
In the real estate business, a property's price is mostly affected by its location. In terms of head & shoulders in trading, the location of it is very important. It useless if it formed in the middle or bottom of a downtrend. Check out this example below:
FCPO formed a head & shoulders pattern when markets had just a downtrend on the left of the chart. Thus this is not a valid head & shoulders price action. If you had shorted when prices broke below the neckline, you will suffer unnecessary huge losses when the market had an uptrend later. Besides that, the timeframe used to identify this price action is also wrong. This is how smart monies make money from impatient traders.
A valid head & shoulders must be formed when the market's previous move was an uptrend. In addition, to avoid false traps setup by the smart monies, it best to find it in the daily timeframe.
How to trade head & shoulders & risk management?
Now you know what is this price action is all about, let us go to the fun part: how to trade it. Check out the part below for an example.
When price broke out of the neckline, you can either short at the market (POINT A) and place your cut loss just above the neckline. Besides that, it may seem counter intuitive to our human nature, you can also short when prices goes back to the neckline (POINT B) with your cut loss also above the neckline. Both of these are valid setups. There is a catch, shorting at point B gives you a much higher risks to reward ratio. Your risks (red box) for POINT B and A are the same but when the downtrend comes, your potential profits (green box) will be much larger if you shorted at POINT B.
In another different matter, you should place a cut loss order. This is because no price action is 100% right all the time. After all, an important aspect of trading is managing your risks well, so you can earn unlimited reward potential. As mentioned above, placing a cut loss above the neckline is a good rule of thumb. This is because when prices starts trading above the neckline for a while, the price action will look like sideways to uptrend biased.
Check out another example of head & shoulders price action below, this time in FKLI.
Here are 2 ways to trade this price action above, but I am not there to talk about what had happened. Hindsight is a beautiful thing. What most important lesson that we can learn from the example above is risk management. You do not have to worry about the market movements, as long as you have 1) place your cut loss order and 2) the cut loss is above the neckline.
Final words
In short, the location and timeframe for head & shoulders are very important so we can identify high quality setups. Once identified correctly, traders can trade on the breakout or on the retracement to neckline, as both are valid setups. Keep in mind, trading retracement to neckline gives us a higher risk to reward potential. In addition, we should also place our cut loss above the neckline, because as professional traders, we know that no price action is 100% accurate all the time.You also can use our advance price actions techniques in Intensive Trend Following course spot higher probabilities trades.
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