Head and shoulders patterns

Every trader has heard, at least once in his activity, about the head and shoulders (H&S) pattern, one of the most famous pattern in the technical analysis. That is simply a chart formation made by a baseline and three peaks, with the outside two lower than the middle one. This famous pattern is used by professional traders to predict a bullish-to-bearish trend reversal, and it is one of the most reliable trend reversal patterns. It signals that an upward trend is nearing its end.

The H&S is observable in forex markets when a currency pair rises to a peak and then declines back to the baseline of the prior upward move. Then, it rises above the former peak to form the so-called “nose” and then again declines back to the baseline. Then, finally, it rises again, but to the level of the first, initial peak of the formation before declining back down to the baselineof chart patterns one more time.

Therefore, a H&S pattern follows a precise sequence of events: after a bullish trend, the price rises to a high and subsequently declines to a first low; it rises again to form a second high placed above the initial one and then declines again; finally, it rises a third time, but only to the level of the first high, before declining once more. The first and third highs are called “shoulders”, while the second is called “head”. The line connecting the first and second low is called “neckline”.

Yesterday, we have discussed about the typical head and shoulders patterns. Nevertheless, sometimes traders observe the formation of an ‘inverse H&S’, a pattern used by traders to predict reversals in downtrends. This pattern emerges when the price action of a currency pair meets the following sequence of events: first, the pair falls to a low and then rises; it then falls below the former low and then rises again; finally, it falls again but not as far as the second low. Once the final low is hit, the price rises toward the resistance located near the top of the previous low. A reverse H&S is a reliable indicator which tells a trader that a downward trend is close to reversion. In this pattern, the currency pair hits three consecutive lows, intervalled by temporary rallies. Of these, the second low is the lowest and is called ‘head’, while the first and third ones are higher and are called ‘shoulders’. The increase taking place after the third fall says that the downward trend has reversed and prices are likely to rise.

It is useful to remind that a price equilibrium in forex markets is always a result of a continuous battle between buyers and sellers. If the majority of traders is bearish on a currency pair and sell it, then this will go down. Otherwise, it will go up. The initial increase and subsequent decline represent the waning momentum of the prior upward trend. Wanting to sustain the upward movement as long as possible, buyers try to push the price back up past the initial high to reach a new one (the head). There, it is still possible that buyers could reinstate their market dominance and continue the upward trend.

However, once price declines a second time and hits a level below the initial high, sellers get the majority. Although buyers try to push price upward, they only push to hit the lesser high reached in the initial peak. This failure to rise above the highest high signals that sellers won, pushing the price downward and completing the reversal.

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