How to avoid getting trapped by common technical patterns
Chart patterns are the tools with which the technical trader does his business…
And they can – in the main – be very useful in successfully building a picture of what’s happening in the markets and predicting, with precision, what can happen next.
But sometimes these patterns deceive us…
They lull us in to a false sense of security and certainty and BAM!
You’ve walked right in to a losing trade as the market goes against you.
So today I want to shed light on how to avoid incorrectly trading one common technical pattern – the Head and Shoulders. And to do so, I’ll look at a period of market action in EURUSD from late last year.
First, let’s examine what the head and shoulders pattern is – here’s a diagram to show you the set up:
First, starting bottom left, we’re in an established uptrend. It will have been going for some time. But it’s hitting resistance (left shoulder) and falling back. Then surging higher again, but hitting more resistance (head) and then slumping.
After the big slump, price tries to move higher once more, before hitting resistance again (right shoulder) and then collapsing lower.
Head and shoulders is a reversal pattern which suggests that the overall trend of a market is exhausted and will change or is changing/about to change.
A common (and optimal) entry into a reversal trade using the head and shoulders pattern is to sell a price close to the neckline of the pattern (as shown above) upon a retest.
So let’s look at a real life example…
Late last year there was a lot of debate online as to where the EURUSD price was heading next and many people were bearish on it, due to the head and shoulders pattern that was forming on the daily time frame.
Now, as I’ve said, using common patterns such as the head and shoulders can be profitable over time – however it is important to know exactly how to use such patterns in your trading, as there is a tendency for the herd to assume that a pattern plays itself out exactly the same time and time again.
But they don’t. And that’s exactly what occurred in EURUSD as and it caught a lot of people out!
Below you can clearly see the neckline of the pattern broken and this triggered a lot of traders to sell a pullback into this neckline:
A few days later after everyone in the world had mentioned the fact that this daily neckline had broken and that EURUSD was going to plummet I noticed something really interesting…
After retesting the neckline we began to sell off (as anticipated), however what happened next is a classic “stitch up” signal and going forward you will be able to spot these in advance of your competition and profit from their mistakes.
As you can see below, we failed at the low of the neckline break – that is to say we traded below but closed above the break, trapping those who were short and forcing them to get long:
Seeing a failure such as the one described here is a great signal for a counter reversal trade and in the case of the head and shoulders pattern, after failure at the neckline break low, price tends to gravitate towards the right shoulder giving you a great trade in terms of risk:reward.
As expected, EURUSD did trade towards the right shoulder of the pattern and there is scope for price to continue higher.
When a counter reversal trade like this plays out so well and traders see that the reversal “failed”, fresh buyers become attracted to the market.
A retest and continuation of the right shoulder suggests higher prices for EURUSD, other than that shorts will become interested again should the neckline break low area get taken out.
If you have any questions on this or are interested in any other technical patterns, just hit reply and let us know.