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Chart patterns are part of buying and selling rules. Most of the time there will already be an open position at the appearance of a price chart pattern. The point is that it gives an important confirmation for the already taken decision. Furthermore, some patterns will help to calculate future price targets.
Medium- and long-term trend reversals are often gradual. The art is to distinguish that you are dealing with a continuation pattern, after which the price will continue its previous trend or a reversal pattern leading to a trend reversal.
The head and shoulders formation belongs with an accuracy of about 90% to the most reliable reversal patterns
Figure 4.39: Head and shoulders top reversal principle.
The price moves in an uptrend. Only after the pattern has formed, you will recognize A as the left shoulder (figure 4.39). The price drops back to the support B of the up-going trendline. From here, the price makes a last move up to C often with lower volume compared to the A move. This will be the head of the pattern. The turning point at B will be part of the neck line.
Next the price drops through the up-going trendline and falls back to the level of the neck line D. After that, the price will move up again to E to form the right shoulder. From here the price will drop below the neck line making lower lows.
The shoulders (A-E) and the neck line (B-D) in the head and shoulders formation should be at about the same price level and at about the same distance in time from the head.
The head and shoulders pattern is confirmed when the price falls below an up-trending neck line or after the right shoulder in case of a down-trending neck line.
ATTENTION! In approximately half of the cases, there is a bounce back up to the neck line G, or even up to between the neck line and the right shoulder.
Figure 4.40: Head and shoulders top reversal pattern.
Figure 4.40 shows an example of a head and shoulders top reversal pattern in the Euro-dollar currency pair.
Mirroring the head and shoulders top reversal pattern gives a head and shoulders bottom reversal pattern. Shoulder bottoms should be at around the same price level and at about the same distance from the head.
The head and shoulders bottom reversal pattern is confirmed when the price moves above a descending neck line or after the right shoulder with an ascending neck line.
ATTENTION! In approximately half of the cases, there is a bounce back down to the neck line or even down to between the neck line and the right shoulder.
Look at figure 4.41 for an example of a head and shoulders bottom reversal.
Figure 4.41: Head and shoulders bottom reversal pattern.