Head and Shoulders
Two of the underlying assumptions behind the validity of using charts and chart patterns are that prices operate in trends and that history will inevitably repeat itself. Therefore, there is value in viewing the price movements of past currency pairs to forecast what the currency pair will do in the future. This is conceptually similar to weather forecasting.
The head-and-shoulders pattern is one of the more popular and reliable chart patterns. And from the name, the pattern somewhat looks like a head with two shoulders.
Figure 1: Head-and-shoulders pattern
The standard head-and-shoulders top pattern is a signal that a currency pair is set to fall once the pattern is complete, and is usually formed at the peak of an upward trend. A second version called the head-and-shoulders bottom (or inverse head and shoulders), signals that a security's price is set to rise and usually forms during a downward trend. In either case, the head and shoulders indicates an upcoming reversal, so this means that the a currency pair is likely to move against the previous trend.
Both of the head and shoulders have a similar construction in that there are four main parts to the head-and-shoulder chart pattern: two shoulders, a head and a neckline. The patterns are confirmed when the neckline is broken, after the formation of the second shoulder.
The head and shoulders are sets of peaks and troughs. The neckline is a level of support or resistance. An upward trend, for example, is seen as a period of successive rising peaks and rising troughs. A downward trend, on the other hand, is a period of falling peaks and troughs. The head-and-shoulders pattern illustrates a weakening in a trend where there is deterioration in the peaks and troughs.
Head and Shoulders Top
This pattern has four main sequential steps for it to complete itself and signal the reversal.
1. The formation of the left shoulder is formed when the security reaches a new high and retraces to a new low.
2. The formation of the head occurs when the security reaches a higher high, then falls back near the low formed in the left shoulder.
3. The formation of the right shoulder formed with a high that is lower than the high formed in the head but is again followed by a fall back to the low of the left shoulder.
4. The price falls below the neckline. In order words, the price falls below the support line formed at the level of the lows reached at each of the three lows mentioned previously.
Inverse Head and Shoulders (Head-and-Shoulders Bottom)
The inverse head-and-shoulders pattern is the exact opposite of the head-and-shoulders top, because it indicates that the currency paid is set to make a move upwards.
Figure 2: Inverse head-and-shoulders pattern
Again, there are four steps to this pattern.
1. Formation of the left shoulder occurs when the price initially falls to a new low and then subsequently rallies to a high.
2. The formation of the head occurs when the price moves to a low that is below the previously mentioned shoulder's low, followed by a return to the previous high. This move back to the previous high creates the neckline for this chart pattern.
3. The formation of the right shoulder. This is typically a sell-off that is less severe than the one from the previous head. This is followed by a return to the neckline.
4. The currency pair breaks above of the neckline. The pattern is complete when the price moves above the neckline created by the previous heads and shoulders.
The Breaking of the Neckline and the Potential Return Move
After the fourth step (when the neckline is broken), the currency pair should be heading in a new direction. It is at this point when most traders following the pattern would enter into a position.
However, there is one scenario where this might not happen and the currency pair subsequently returns back to the previous trend. This is known as a "throwback" move, which occurs when the price breaks through the neckline, setting a new high or low, but then retreats back to the neckline.
Figure 3: Throwback move illustration
While it may be an issue to see a currency pair return to its original trend, it might not be a serious concern. The throwback could be a successful test of the new level of support or resistance, which would ultimately help to strengthen the pattern and further confirm its new trend. So, some patience is required in order to wait for the pattern to test out and not close the position out too quickly - before the pattern makes its bigger moves.
The goal of this portion of the walkthrough was to expose you to some of the basic technical analysis tools that are used by forex traders. Candlestick charts are commonly used as they are able to reveal a wealth of data at just a glance. Figuring out a currency pair's current trend can to be a good indicator of where it will go for the near future. Chart pattern can be used to forecast and confirm upcoming trends. For example, the head and shoulders patterns can indicate that a currency pair will be undergoing a reversal in its trend. While charts and chart patterns are a big part of forex trading, it is still important learn about some of the fundamentals behind forex and currencies. In the next section, we will expose a little bit behind the basic economic theories involved in forex trading.