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The Head and Shoulders Pattern.

What is a head and shoulders top pattern?
In the head and shoulders top pattern, an initial rise is followed by temporary decline, creating the left shoulder. Subsequently, the price rises past the initial peak and once more declines, formulating the pattern’s head. The price escalates again, this time rising only as far as the initial peak of the formation forming the right shoulder. The pattern is considered complete when the price drops below the neckline. This is represented by a line which connects the two drops of the formation, extending to the right.

This reversal pattern frequently appears on the top of an extended uptrend. The pattern is negated when the price fails to break the neckline and instead, heads higher.

ChartPattern_HeadShoulderTop

What is a head and shoulders bottom pattern?
In the head and shoulders bottom pattern, an initial fall is followed by temporary rise, creating the left shoulder. Subsequently, the price falls past the initial low and once more rises, formulating the pattern’s head. The price falls again, this time falling only as far as the initial low of the formation forming the right shoulder. The pattern is considered complete when the price rises above the neckline. This is represented by a line which connects the two peaks of the formation, extending to the right.

This reversal pattern frequently appears on the bottom of an extended down trend. The pattern is negated when the price fails to break the neckline and instead, heads lower.

head-and-shoulders-pattern-inverted

Example: How can we trade the head and shoulders pattern?
headandshoulders1

The following example of the USD/JPY illustrates a head and shoulders formation on a daily chart. After an abrupt rally, the pair temporarily retraced, forming the pattern’s left shoulder. Thereafter, the price ascended once again, reaching a new high. Soon after making the new high, the pair dropped once again, forming the pattern’s head and neckline. The pair rallied again, only to reverse around the left shoulder’s high. Once the pair fell below the neckline, the odds of a bearish breakdown increased prompting a potential sell.

Because the pair broke the pattern’s neckline, we sold USD/JPY at 96.67. We placed our stop-loss at 97.80, slightly above the formation’s neckline, allowing the trend to fully develop. The USD/JPY continued to drift lower in the desired direction, dropping over 200 pips over the course of next week.

headandshoulders2

About Ziad Melhem

Ziad Melhem
Ziad Melhem is the Admin of Forex.com.lb with more than 10 years of experience in the local and regional "financial wheel". With vast experience in equities, capital markets, foreign exchange, derivatives, technical analysis, and financial services, he is one of the pioneers in online trading when this financial product was first introduced to Lebanon around 2000-2001. Ziad is currently the CMO of Amana Capital Group (www.amanacapital.com).

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