Traders tend to focus too much on timing the correct entry into a trade, but very few focus on developing an exit strategy. If you sell too early, substantial profits remain on the table, and if the position is held too long the markets quickly snatch the profits back. Hence, it is necessary to identify a trade and close it as soon as the trend reverses.
A classic setup that is believed to be reliable in detecting a trend reversal is the Head and Shoulders (H&S) pattern. Over long periods of time, the H&S pattern doesn’t form often, but when it does, traders should be careful and act accordingly.
Let’s look at a few ways to spot the H&S pattern and decide when to act on it.
Head and shoulders basics
The H&S pattern forms after a bullish phase and suggests that a trend reversal may be imminent. As the name suggests, the formation consists of a head, a left shoulder, a right shoulder and a pronounced neckline. When the pattern completes, the trend usually reverses direction.
The above picture shows the structure of an H&S pattern. Before the setup is formed, the asset is in an uptrend. At the peak where the left shoulder forms, traders make profits and this leads to a decline. This marks the first low, but is not yet strong enough to provoke a trend reversal.
Lower levels are attracting buyers again as the trend is still bullish and buyers manage to push price over the left shoulder but cannot sustain the uptrend.
Profit booking by the bulls and short selling by counter-trend traders pull the price down, which finds support near the previous lows. The connection between these two troughs forms the part of the setup.
As price bounces off the neckline, the bulls make one more attempt to resume the uptrend, but when price hits the high near the left shoulder the profit booking kicks in and the rally fizzles.
This lower peak forms the right shoulder and is usually in line with the left shoulder. The upward trend is reversed and sales are picking up speed. Finally, the bears manage to pull the course under the clipping. This completes the bearish pattern and the trend reverses from bullish to bearish.
Detect trend reversals with the H&S pattern
Bitcoin (BTC) started a strong upward move after breaking out of $ 20,000 in December 2020. The BTC / USDT pair hit a local high at $ 61,844 on March 13, and the price corrected and bottomed on March 25. This local high was the left shoulder.
The bulls viewed the dip as a buying opportunity as the trend was still up. Aggressive buying then drove the price above $ 61,844 and the pair hit a new all-time high of $ 64,854 on April 14. This level attracted sales which dragged the price down, making the second low on April 25th. The middle high above the other peak formed the head.
Another attempt by the bulls to resume the uptrend failed on May 10th. This formed the right shoulder and the subsequent correction broke below the neckline of the pattern. The breakdown and closing below the neckline on May 15th completed this bearish setup.
Sometimes, after the breakdown, price retests the breakdown level from the neckline, but if momentum is strong the retest may not take place, an example shown in the graph above.
To calculate the pattern goal of this setup, determine the distance from the neckline to the top of the head. In this case, the value is $ 15,150. This distance is then subtracted from the break-through point on the neck line to meet the minimum target goal.
In the example above, the breakdown occurred at nearly $ 48,000. This projected a sample target of $ 32,850. This number should be used as a guide as sometimes the decline exceeds the target and in other scenarios the downward movement ends without reaching the target.
The head and shoulders sometimes fail
Sometimes traders jump in and take counter-trend positions before price falls below the segment of the evolving H&S pattern. In other cases, breaking below the neckline will not result in repeat sales and the price will climb back above the neckline. These cases can result in a failed setup, trapping the aggressive bears that are forced to cover their positions and this results in a short squeeze.
Cardano (ADA) started an uptrend from the $ 0.10 level on November 20, 2020. The uptrend encountered resistance in the $ 0.35 to $ 0.40 zone in January and an H&S pattern began to develop. The price fell to the neckline on Jan 27, but the bears failed to decline and close the ADA / USDT pair below the support.
When the price bounced off the neckline on Jan. 28, it was a signal that sentiment remained bullish. There were minor hiccups on January 30th and 31st as the bears tried to stop the upward move near the right shoulder, but continued buying by the bulls sent the price skyrocketing on February 1st. This breakthrough over the head of the pattern invalidated the establishment.
When a bearish setup fails, several aggressive sellers are caught off guard. This creates a short squeeze and drives the price up. The same thing happened in the example above, and the pair soared in February.
The central theses
The H&S pattern is believed to be a reliable reversal pattern, but there are a few important points to keep in mind.
A downward sloping or flat cutout is considered to be a more reliable pattern compared to an upward sloping cutout. Traders should wait for the price to drop below the cutting line and close before initiating trades. Anticipating the setup could result in losses as a failed bearish pattern could result in a strong rally.
The pattern targets should only be used as a guide as sometimes price can overshoot and continue to move down, and at other times it can reverse direction before reaching the target target.
The views and opinions expressed are those of the author only and do not necessarily reflect the views of Cointelegraph.com. Every step of investing and trading involves risk, so you should do your own research when making a decision.