Professional Look, Part 2
In the first part of this article, we looked at some of the differences to keep in mind in a head and shoulders pattern, beyond simply finding the higher and lower highs that most traders usually focus on (see in the last issue of the magazine).
We have indicated that the pattern should form after an established uptrend (with a minimum of 2 retracements) and preferably after an extended trend.
In the first part, we focused on the example of a potential head and shoulders pattern and wondered if it is worth going short on this pattern. But, then, I probably caused bewilderment among many novice traders, saying that many professionals would actually look for an opportunity to trade long in that situation.
Now, let’s take a look at our next diagram to see what happened next.
The configuration that looked like a head and shoulders pattern transformed into a complex ABC retracement and then the market continued its uptrend.
Many people probably have a question: how did the professionals know that this would happen?
First of all, let’s be clear about one thing – the professionals “didn’t know”.
Nobody knows what this or that market will do in the future. The only thing that professionals know is that the market can do anything, anytime.
But professionals play on probabilities, and the continuation of the trend is more likely than its reversal.
In general, trending trades have the best win / lose ratio, and trend reversal trades have the best risk to reward ratio.
Professionals can also look at other factors, such as a larger time frame and trend momentum.
Alternatively, the pros may actually go short on the head and shoulders, but be prepared for this configuration to turn into an ABC retracement and the trend continues. And when that happens, they may be fully deploying their positions. Flexibility is a sign of a professional trader.
But, there was another key indication that the trend might actually continue rather than reverse.
Many novice traders only look at the highs when trading head and shoulders. They focus on the higher and lower highs, but ignore the lows, which is a big mistake.
It is the lows that reveal the real picture and give an understanding of the psychology of what the market is most likely to do in a head and shoulders pattern.
Pay attention to the third diagram (in part 1) price not only made a lower high, but that lower high was preceded by a lower low.
This may look favorable for entering a short position. After all, isn’t this additional confirmation that a new downtrend is starting?
In fact, the answer is not so straightforward.
Novice traders using technical analysis are too fascinated by chart patterns, as if there is some magic power in them. In fact, this is not the case – the only reason why certain price models provide probabilistic scenarios for trading is related to the psychology of market participants.
Remember, it is the market participants that make the markets move up or down, and these moves are based on their trading positions, their greed and fear. Charting patterns are simply representations of the behavior of traders.
Here’s how it works for the head and shoulders model:
The market was in an uptrend, so many participants held long positions. Therefore, it is only natural for many of these traders to place their stop orders below the previous low.
If the market makes a lower low before it makes a lower high, then many traders who were long have now exited their positions. They don’t feel uncomfortable because they have captured some of their profits. Therefore, it is less likely that the market will make a quick and sharp decline from the lower high that was formed after that. Traders are not “trapped” and this reduces the likelihood of emotional selling that would otherwise occur.
Conversely, if the market makes a higher low and most participants have not been knocked out of the market, and then a lower high forms and you enter a short position, then you have the potential to capture a quick and sharp down move.
If the market then breaks the previous low, then you are now ahead of anyone who will exit long positions, as they are “taken by surprise”.
The key here is for you to enter the market before longs are able to relieve pressure by being on the wrong side of the market. You want their emotions to move the market down after you enter, not before you take a position.
Many traders will close their long positions when these levels are crossed. In addition, there will also be those who will place pending orders to open short positions when these support levels are breached. So, again, you should be in the market in front of these breakout traders.
Each successfully-broken low leads to more sales, which may continue to drive the market further and further down. Now, we are in a downtrend, but we entered it before it started. The risk / reward ratio in this scenario (assuming you will hold at least part of your position during the new downtrend) is phenomenal.
Figure 5 shows another interesting take on this pattern, which adds potential for a cardinal reversal pattern and a new trend forming in the opposite direction. When a head and shoulders pattern is formed in this way, a pattern within the pattern emerges.
A higher low and a lower high form a triangle pattern at the top of the trend. There can be 2 explanations for this:
After a trend, during which there may be high volatility, the “triangle” is a low volatility pattern. This allows you to play one of the market cycles: they alternate between periods of high and low volatility. Entering during a cycle of low volatility (like a triangle) can allow you to position yourself with a major impulse move when the cycle of high volatility begins again. Institutional and large traders are unable to quickly enter and exit their trades due to the size of their positions. If they execute a trade at once with full volume, it will move the market too quickly and they will not get the price they would like to have on their trade.
Therefore, at the top of the trend, they use “distribution” techniques whereby they sell off their positions in small chunks so as not to move the market too much. Thus, they can close most or all of their long positions at a high price. This forces the market to consolidate at these levels before the reversal occurs, and one such pattern of consolidation is the triangle. Thus, by entering the market within the “triangle” model, you can potentially position yourself with major players.
Chart patterns can be a very powerful tool in your trading plan if you do not blindly trade the patterns, but understand and consider the psychology and behavior behind these patterns.
Remember that chart patterns alone are not enough to trade successfully. They are just one element of a comprehensive and well-thought-out trading plan, along with considering other market drivers like momentum, volume, and a larger time frame. And, all of this must be topped with impeccable money management.