Head and Shoulders Pattern

*Bob Iaccino, Chief Market Strategist and Co-Founder of Path Trading Partners, joins us live every Thursday from 11am ET, as our risk management educator. With 30 years' experience working as an active investor in equities, commodities, futures and FX there are few better to talk on the subject of risk management.

Bob has developed a method for breaking down his key fundamentals of risk management, in a way that he thinks retail traders can understand and use to get actionable insights to bring into their own trading. Below are some excerpts of Bob’s thoughts from a recent live session.

In a head and shoulders pattern, there is a shoulder, a head, and another shoulder. It consists of a rounding formation, followed by a higher rounding, and then another rounding.

It's important to note that there are both head and shoulders patterns and inverse head and shoulders patterns, also referred to as head and shoulders bottoms by some traders.

These patterns are always reversal patterns, similar to double tops and double bottoms. They often resemble double tops and bottoms, but with an additional rotation. However, there are some very specific characteristics, just like with double tops and bottoms.

My partner, Mike Arnold, and I spent years analyzing data to develop higher probability ways to trade these patterns. We are very strict in how we interpret these particular formations.

The target for a head and shoulders pattern is based on a measured move. To determine the measured move, first identify the high of the head and measure straight down to the approximate level of the neckline. Subtract the difference between the two. Once the neckline is broken, subtract the number you calculated from the price at the break of the neckline, and that will give you your target. You would typically go short when the price breaks below the neckline.

A target is a point where action is required, not optional. You must take action at your target, especially if it’s a measured move target, because you identified that target well before you entered the trade. Therefore, that target is important. The only time you can think clearly about a trade is before you're in it.

A common mistake many traders make is when they see the price approaching the target, they think, "Oh, I'm almost at my target," and feel relieved. But then the day closes, and the next day the market opens lower—remember, this green area is the open, and the bottom of this candle is the open. Suddenly, you're thinking, "Oh my God, I'm going to make a fortune on this trade."

In that excitement, you might prematurely exit your trade or fail to adjust your stop. You don't tighten your trailing stop, or you hesitate to reduce your stop loss because you don’t want to get stopped out. This behavior is careless and could cost you profits.

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