Professional and profitable trading strategies have to be SIMPLE. Trading is already very hard and dealing with emotions, controlling risk management and responding to changing markt cycles is not easy and that is why your trading strategy has to be simple to avoid mental clutter.
Of course, simple does not mean that it is going to be easy, but a simple trading strategy allows you to understand your charts in an effective and efficient way. You have to be able to look at a chart and see instantly if there is a trade or not. In my trading, if I have to spend more than 30 seconds looking at a chart, wondering if there is a trade, it’s a clear sign that I am forcing something that isn’t there. The best trades will jump at you.
The best Forex pattern
The best trading pattern is the Head and Shoulders and even literature suggests that the Head and Shoulders provides high predictive value (read Schabaker’s book about technical analysis). But why is it that the Head and Shoulders works so well? For that, we have to look at the individual parts and components of this pattern and see how much information such a chart really provides. You’ll be surprised to learn the depth of market information one can gain by looking very closely at the Head and Shoulders.
Here we see last week’s inverse Head and Shoulders on the AUDUSD chart and some of our pro members traded that successfully as it was a beauty of a chart.
Let me walk you through it from left to right (starting just before the Head and Shoulders) to see what we can learn from it:
- Price was in a downtrend with very long and strong bearish candles (this shows strong selling momentum)
- The closer we moved into the left shoulder and the head, the smaller the trend waves became (this shows fading interest)
- The trend wave leading to the head was just barely able to break the previous lows which clearly shows that the sellers are not really as interested anymore -this does NOT mean to buy yet!
- The right shoulder then shows the first higher low and here it becomes clear that buyers are more interested and the buying interest does not allow price to fall as low anymore. We don’t have a higher high yet so still not a signal.
- Then we break the neckline and make a new high which shows that the sellers are not stepping in as early to drive price down. The break of the neckline is the buy signal on a Head and Shoulders
- The new uptrend gains strength without any opposition from the sellers
Why does it work?
It’s important to understand the rationale behind the patterns you use because it allows you to trade them with more confidence. In the case of the Head and Shoulders, it’s very obvious and straight forward what it tells us about the market and the trade.
- A price chart is defined through trend waves and the way trend waves manifest on our charts, it shapes trends, ranges, reversals and consolidations
- A downtrend can only exist on our charts if the trend waves keep pushing lower. If the sellers are strong enough and the selling interest outnumbers the buying interest, price will fall
- The distance between the lows shows us how strong the sellers really are. If the lows are far apart from each other without strong corrections, the selling interest is significantly larger than the buying interest
- When you then see that the lows are barely able to push lower, it means that the sellers are withdrawing from the markets, that buyers are coming in more and/or that the sellers are also taking profits
- When price then fails to make a new low, it shows that the buyer/seller dynamic is shifting towards more buying interest
- The break of the neckline is the final piece to the puzzle and it shows that the buyers can move price into new highs and that the sellers have completely withdrawn themselves from the market
You see, the head and shoulders is not just a random signal that shows us when to buy or to sell, but it describes the rhythm of the market. I enjoy watching the markets from such a perspective because it really feels like you are following the buyers and sellers and wait for that moment when the powers shift.
The Head and Shoulders is a universal principle that works on all timeframes and all markets.
There is a little more to the Head and Shoulders than just looking at a neckline break and the quality of such a setup can be improved significantly if you know what you are looking for.