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Head And Shoulders Candlestick Pattern

Head and shoulders is a term that refers to a type of pattern-also called a trend-that is useful in gauging future market values of financial assets. In particular, the term can refer to the price behavior of stocks with respect to time; nevertheless, for our forex investment concerns, the term will refer to the nominal exchange rate between USD and some other tradable foreign currency.

To simplify matters, let us fix a foreign currency that we can talk about, say EUR, so as to make this discussion more concrete. We present an example where we track a fictitious value for the EUR/USD rate over the month of June in a particular year. We will refer to the following graphic.

We wish to explain how this graphic exemplifies the notion of head and shoulders. The main properties that the above exchange rate has are as follows. It makes an initial rise, peaking but then falling. After the initial fall, the rate then peaks at an even higher level, subsequently falling again. It is important that this second trough be at a lower level than the initial peak. The trend is called head and shoulders because the graphic resembles the head and shoulders of a person. Finally, the rate rises again, but to a level lower than the second peak. In terms of the specific data in the graph, the initial peak is at EUR 1.25/USD 1 on June 7th, the second peak is at EUR 2.1/USD 1 on June 15th, and the final peak is at EUR 1.45/USD 1 on June 20th.

Now that we've described head and shoulders, we will try to explain why investors care about trends and explore what the head and shoulders trend tells the investors about a particular currency exchange.       

Trends are useful in evaluating whether a particular investment is prudent or not based on recent empirical data. Put simply, a trend is the general movement associated with the price of an asset or currency. We present a graphical example of a fictitious upward trend of the same exchange rate. A downward trend in the exchange rate would be given by exactly the opposite scenario: a graph whose exchange rate values gradually decrease on average.

As an investor, one hopes to jump into the market during an upward trend with the expectation that the market will continue to rise, thereby increasing the value of his investment. Conversely, an investor would like to leave the market and cash out in USD during a downward trend, when it seems like the investment will begin to continually lose value. This is to say that in general, an investor should aim to trade with trends, buying during upward trends and selling during downward trends.

Upward and downward trends are easy enough to identify. The most useful lesson that an investor can retain from this discussion is how to distinguish long-term upward and downward trends from trends that only mimic upward and downward movements in the short-run. That is to say that there are ways to tell if a trend will be sustained in the long-term future. In particular, what we are interested in is the head and shoulders trend, a trend that seems like it indicates an upward trend but which, more often than not, is an indicator of a turn in the market.

The question that most people have, when they hear that the head and shoulders trend signifies a reversal in the market, is why this should be case. Generally, this trend reflects uncertainty on the part of traders. The initial shoulder represents an initially high volume of level of trades for USD. The initial trough and the second peak represent decreased, then increased, confidence in USD. The final trough, peak, and fall represent another flirtation with USD but an ultimate shift away from USD.