FX Trading with Chart Patterns: Head and Shoulders

When it comes to FX trading the one thing most traders agree on is the fact that you can’t use a single approach or type of analysis if you want to succeed. In other words, you can’t focus solely on fundamental analysis without paying attention to technical analysis nor can you focus on a single indicator and ignore other forms of technical analysis.

Therefore, an effective FX trading system should include components from both styles of analysis as well as different types of technical analysis. One component that you should not overlook in your trading system is the chart pattern. The latter serve to help traders identify potentially large movements in price before they happen.

One of the main advantages to chart patterns is that they act a little like self-fulfilling prophecies. This is because, in FX trading, the market moves based on trader behavior as much as it does according to economic data. Therefore, when most traders are looking for the same patterns and have the same expectations which they act on, the price will move in the direction of their expectations.

A clearer explanation would be that if a large number of traders identify a chart pattern that signifies a potential upward breakout of price, they will begin buying above the resistance level. Thus, the high volume of long positions will start to drive the price up and traders’ expectations will be fulfilled.

Head and Shoulders

There are many chart patterns in FX trading, but one of the most important is the head and shoulders pattern which usually signals that the current trend is coming to an end and is likely to reverse. This patter is formed by three peaks, where the first peak is slightly lower than the second peak and the third peak is lower than the second. The second peak forms the head while the other two peaks form the shoulders.

A neck line or support level is plotted between the lowest points of the valleys between the peaks. This line can either be horizontal or at a slope.

The head and shoulders pattern most often appears during an upward trend and indicates that the trend is about to reverse and the market will turn bearish. Therefore, you would place a sell order slightly below the neck line to catch the downward movement.

The head and shoulders pattern also allows traders to determine about how far they should expect price to move so that they can have their exit in place. The way to do this is to measure the distance between the neck line and the head, or the highest peak. The resulting number of pips should be your profit target as that is about how far you should expect the market to move.

Reverse Head and Shoulders

Just like its counterpart, the reverse head and shoulders pattern is a useful tool in FX trading to determine a trend reversal. However, in this case the pattern usually appears during a bearish trend and indicates that a bullish trend might be ready to start.

The reverse head and shoulders pattern is the mirror image of the head and shoulders pattern and looks like three Vs linked together where the tip of the second V is lower than the others. In this case, you would place a buy order above the neckline and trade as you would if you were trading a regular head and shoulders pattern.

In FX trading, the trick is not to be greedy because even though the market might move significantly further than your profit target, it is just as likely to reverse. Therefore, rather than lose all your profits you should be happy with what the market gives you. After all, the best profits are those you keep and not those you might have made.

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3. The Forex Market Trade: The Pitfalls of Indicators
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6. Forex Technical Studies: The Analyst’s Essential