A head and shoulders pattern is a traditional forex trading pattern that is used for catching reversals in the market. In this short article, we’re going to cover how traditional retail traders approach this pattern, how to identify it, and how we at Phantom Trading interpret this pattern as smart money concepts (supply and demand) traders.
There is more to this pattern than what meets the eye, and while it’s a valid way to look for a reversal in an up-trending market from a traditional trader’s perspective, there is a better way to look at these patterns and play them!
What Is A Head And Shoulders Pattern in The Forex Market?
The head and shoulders pattern really consists of four different components and again is considered a reversal pattern that new traders look for in order to take profits in a long that they were already in, or in order to look for shorts.
The Four Parts of The Head And Shoulders Pattern
The reason the head and shoulders pattern is named as such is that it literally looks like a head between two shoulders!
- The First Shoulder
- The Head
- The Second Shoulder
- The Neckline
As shown in the diagram above, we can see that price is trending up, but starts to create a pullback (shoulder 1), breaks the first shoulder (creating the head), then respects the low (at the neckline), creates a third high which is lower than the previous one (shoulder 2), and eventually the neckline breaks.
How The Average Trader Would Use The Head And Shoulders Pattern In Their Trading
Your average trader would look to enter the market or set a stop limit order in order to catch the breakout, leaving the stop loss either above the second shoulder or above the head of the pattern formation like so:
However, as you can see in the diagram above, traders who use this pattern are normally going to make only 1R to 2R on a trade like this because they’re using it to catch a breakout to the downside.
While this isn’t bad per se, your average trader is usually just looking for this pattern without any awareness of the higher timeframe trend, nor are they aware of whether the price is tapping into something to the left (supply level) to use as a catalyst to improve the probability of the move.
The fact is, this pattern can show up anywhere and can sometimes provide fake setups. Since it’s a reversal pattern you run the risk of trading completely against the trend.
How A Phantom Trader Sees The Head And Shoulders Pattern
At Phantom Trading, we have a much more robust way of looking at basic technical trading patterns like this. The first thing we’ll do is look to identify the characteristics of price and ask ourselves, “Why are we starting to see price exhaustion?”
To dig deeper into that question we’ll then look for the following to get a sense of whether or not this is a high probability head and shoulders pattern that we can play:
- What is the Higher Timeframe Trend (4-Hour, Daily, etc)?
- Are We Tapping Into A Higher Timeframe Supply Zone (4-Hour or Daily POI)?
- What Does The 15-Minute Orderflow Tell Us?
- Is Resting Liquidity In The Market Being Swept (Price Manipulation)?
- Is There Any Liquidity That We Can Target On The 15 Minute Chart?
- How Can We Enter The Trade?
It may seem complicated, but is it essential that we do our due diligence and see if there are enough confluences in the market to determine whether or not a trade setup is high probability or not?
Our higher timeframe trend, in this case, is bullish on the daily chart as shown below, and we can also see that we’re tapping into a daily level of supply too.
This of course means that we are trading counter-trend, which is okay, but at least we can justify why price may pull back or “reverse” in the short to mid-term (because it’s tapping into a daily supply zone).
Looking at the 4-Hour we can then see in this example how we are also bullish on the 4-Hour timeframe (4-Hour structure is marked with the grey dots), and that we’re tapping into a nested 4-Hour supply level to the left.
We can see from this timeframe that price is clearly exhausted after this big move, so we can potentially expect price will likely retrace or pull back from here.
Finally, looking at the 15 Minute we can see that there is a clear sweep of liquidity (the first shoulder), bearish 15-minute orderflow in the form of a 15-minute supply chain at the top of the head, and more liquidity to use as inducement between the head and second shoulder.
As you can see in the diagram above, you’re looking at a trade that is not only more thought out and higher probability (because we did a deep multi-timeframe analysis on it), but we were also able to catch a trade that ran 12.5R (or 12.5x more profit on our trade versus what most traders would bank on it).
While the average trader has a massive stop loss and smaller position size as well as a worse fill on their order, we are able to catch the trade on the 15-minute and profit much more from the exact same move in the market!
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Robert Castillo – Currency & Commodities Trader,
Financial Analyst, Writer & Editor.
Robert is a funded trader based out of Toronto, Canada, and has been trading currencies, commodities, stocks, and cryptocurrencies for over 7 years. Outside of trading he enjoys producing music, mixed martial arts, and riding his motorcycle in the summer.