It is believed that every moving thing has patterns which keep repeating over the course of time. Well, stock market is no exception for that as well. And what’s better to tell that other than charts. Stock markets are in a constant run. For the outsiders, it may look like they are moving randomly but for the trained eyes, it is filled with patterns. Patterns can be found in any form. Such as candlestick, technical, indicators etc. And trust me, if it weren’t for patterns, nobody would’ve been able to make money out of it. Because patterns are what make it speculative and that increases the probability of trading outcome.
There are hundreds of tradable patterns which can be spotted on charts. Some of them are so common that you can just randomly place a finger and you may land on a pattern. But how many of them have the probability is the question here. Some patterns are bound to fail. But some patterns can be turned into jackpot opportunities if you trade them carefully. Many traders made their fortune by trading one pattern. E.g., Paul Tudor Jones predicted the crash by following MACD and made a fortune.
“I fear not the man who has practiced 10,000 kicks once, but
I fear the man who has practiced one kick 10,000 times.”
Just like the quote, if you went and tried all the patterns, you will not gain anything from it. All you have to do is master one pattern and you can make a living out of it. And one of the high probable patterns (& my favorites) is the ‘Head and Shoulders Pattern/H&S Pattern.” If you are unfamiliar with the pattern then just looks at image at the start. It’s all you need to keep in mind for now.
H&S pattern is the reversal pattern and is often found at the top/bottom of the trend. It is a time-consuming pattern which increases its odds of working in the favor and presents much convincing trade opportunity than most of the other patterns. The H&S pattern that is formed at the bottom is also known as The Killroy pattern in some countries.
The first i.e., left shoulder indicates that there’s a resistance at the top of it. When the head forms by taking out the previous resistance & retraces back to the neckline, that’s when you know that bulls have exhausted and cannot take the price any further. And that’s the time to track the chart closely and check if the right shoulder forms or the resistance of head gets taken out. If it doesn’t and reversed from the similar level as first shoulder then follow the neckline rigorously. That’s where the pattern completes because, for the 3rd time bulls
have failed to take price further and the reversal will be strong.
This is the daily chart of JETAIRWAYS. I’ve drawn the pattern for the viewer’s convenience. The stock made a big H&S pattern at the top of the trend. It was also the opportunity for the investors to offload the shares before turning it into the disaster that it is today. Notice the highlighted area below the neckline. It was the last signal to exit. After that look at the fall.
How to trade it?
When it comes to trading, there are thumb rules for every pattern. And rules come in handy because not every H&S comes in your way has a textbook structure. There are complex varieties of it as well. E.g., sometimes shoulders are not of equal heights or there could be 2 heads as well. Rules can be classified in 3 parts, Entry, SL & Exit.
Entry & SL The general rule to enter is 3% below the neckline. But there are some other ways to enter too. Like, once the neckline is broken, wait for some pullback. Pullbacks are healthy because they help to shake the weak hands. Place the trade below the pullback low wait for the trigger. Once your trade is executed, place the stop loss just above the neckline. And yes, you have to consider the position sizing with stop loss in mind. Don’t trade without proper risk management.
Exit Now that you have entered the trade. The next question is where to exit? And it is one of the biggest dilemmas of new traders, where to book profits? Because with green MTMs, greed also comes. Always have the targets already decided. In this case, the usual target is the same distance between the neckline and the top of the head. Major it from the neckline below, and when you see the price there, just take the exit and be happy. Because you can never take everything from a trade. There’s always some money left on the table.
Above information is given for the top formation of H&S. Same can be used for bottom reversal.
I hope you understand the basic concept of the H&S pattern & it’s implications. Go through as many charts as possible. Notice the pattern and its aftermath. Observe the price action around the pattern. You’ll get a good amount of knowledge just from one pattern. And that’s the mantra to scale up in trading business.
Until the next blog…