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What is a shooting star candlestick pattern?

A shooting star pattern is found at the top of an uptrend, when the trend is losing its momentum. The shooting star is actually the hammer candle turned upside down, very much like the inverted hammer pattern. The wick extends higher, instead of lower, while the open, low, and close are all near the same level in the bottom part of the candle. The difference is that the shooting star occurs at the top of an uptrend. It’s a bearish chart pattern as it helps end the uptrend. The inverted hammer, on the other hand, is a bullish chart pattern that can be found at the bottom of a downtrend and signals that the price is likely to trend upward. <img alt="shooting star candlestick pattern" src="/TMXWebsite/media/TMXWebsite/Shooting-star-pattern_1.jpg" /> Both the green and red versions are considered to be shooting stars although the bearish (red) candle is more powerful given that its close is located at the mere bottom of the candle. Again similar to a hammer, the shadow, or wick, should be twice as long as the body itself.    In general, the longer the wick the stronger the reversal, since the long wick signals the inability of the bulls to secure a high close.    Some traders prefer to wait and see whether the next candle is a bearish one, which will confirm that the reversal is taking place.  In both cases, an occurrence of the shooting star at the top of an uptrend only generates a signal of an impending reversal and it shouldn’t be taken as a direct trading signal. <h2>What a shooting star will show us</h2> As outlined earlier, a shooting star is a bearish reversal pattern which signals potential change in the price direction. The uptrend is nearing its end as the momentum is weakening, and the sellers are feeling more confident that they can force a reversal in price action.    For this reason, a shooting star candlestick pattern is a very powerful formation. Its shape gives the pattern a lot of attention as the wick always sticks out from the rest of the price action.    This is especially the case when the wick of a shooting star is also the new short-term high.    Thus, although the buyers were successful in pushing for a new high, they failed to force a close near the session’s high. Their inability is now a chance for the sellers to reverse the price action and erase previous gains.    Therefore, the shooting star’s key strength is its ability to generate a reversal signal. Of course, it may not always be right, but it is considered to be effective and reliable. However, please note that this is still one signal generated by one of hundreds of technical indicators.  For this reason, it is important to always cross-check the signal that a shooting star generates with other indicators, or other <a data-di-id="di-id-249ef9e4-1d3b3793" en="" forex="" href="" japanese-candlesticks="" trading-academy="">candlestick patterns</a>. For instance, in the vicinity of a shooting star there may be other formations that signal the reversal or indecision. You can try your hand at spotting the shooting star pattern along with other technical indicators using the <a data-di-id="di-id-249ef9e4-1d3b3793" href="/en/metatrader5">Metatrader 5 trading platform.</a> <h2>How to trade the shooting star pattern</h2> Trading the shooting star formation is similar to trading a hammer. The focus is on the candle itself of course, especially its wick that extends higher. In the example below, we see a AUD/USD chart that moves in an uptrend. In the middle of the chart, the price action corrects lower just to get back higher again and quickly. What follows is the fresh high in the context of a long bullish candle. If you look at this candle only, the situation looks very positive for the bulls, as there is an uptrend in action and the new high has just been posted. <img alt="AUD/USD trading the shooting star pattern" src="/TMXWebsite/media/TMXWebsite/chart-2-shooting-star_1.jpg" />   However, the situation quickly changes. The price action moves higher again in the session, fails to create a new high, and reverses to close at the low of the session. As a result, a shooting star candle is formed.    The next candle is a long bearish candle that confirms that a reversal is taking place. Ultimately, the price action retreats 250 pips lower.  Whenever you decide to trade the reversal that was initiated by a shooting star, the stop loss should always be placed above the candle’s high. This is arguably the greatest strength of this pattern, and as it is with a hammer, it gives you a clear level to play against.   Any sustainable move, with a high close, above the candle’s high, invalidates the pattern. Take-profit order is dependent on your trading style and risk management. Our advice is to consult other indicators, like <a data-di-id="di-id-3e8356ea-b9dbef8f" href="/en/trading-academy/forex/analysis-fibonacci-ratios">Fibonacci</a>, trend lines, or moving averages, and decide whether to exit a positive trade or not.   To demonstrate this, let us move your attention to a chart below. We have a NZD/USD trading sideways for the most part. In the middle part of the chart, the price action starts to move gradually higher.   <img alt="NZD/USD trading the shooting star pattern" src="/TMXWebsite/media/TMXWebsite/chart-3-shooting-star_1.jpg" />   At one point, there is a new high in place, above the horizontal resistance. However, the buyers lose control over the price action, which initiates the pullback. A failure at important resistance/support levels is not a normal failure, it is usually much more important. For this reason, the price action rotates back lower following a failure to clear the resistance and returns to support.    The upper red line shows our stop-loss, which is around 20 pips above the session’s high. Any move to these levels where our stopp-loss is means that the pair is in a breakout territory and there is no reversal.    Our profit-taking order (the lower horizontal black line) is a simple trend line that shows where the pair bottomed during the previous attempt to move lower. Hence, we are looking for a pullback to the old support.    In this situation, we are risking 20 pips to earn nearly 90 pips. A simple calculation shows that it is a 1:4.5 risk ratio, an extremely profitable trade. Opportunities as profitable as this one are quite rare in the markets, but this does demonstrate how powerful a shooting star candlestick pattern can be. Before you start risking your own capital, you may want to consider<a data-di-id="di-id-52b20e36-40a28506" href="https://portal.thinkmarkets.com/account/individual/demo" target="_blank"> opening a demo trading account.</a> This way, you will practise with virtual funds and equip yourself with an array of trading patterns and formations to apply when you start trading live.     <h2>Summary</h2> A shooting star is a single-candle bearish pattern that generates a signal of an impending reversal. Similar to a hammer pattern, the shooting star has a long shadow that shoots higher, while the open, low, and close are near the bottom of the candle.    It is considered to be one of the most useful candlestick patterns due to its effectiveness and reliability.   The long wick extending upside signals the buyers’ inability to follow up on the earlier move higher, which provides the sellers with an opportunity to initiate a change in the price direction.

6 min readAll

Forex Indicators and patterns

What is the Bill Williams Awesome Oscillator?

The Bill Williams Awesome Oscillator is an indicator that traders use to measure momentum in a market. Like all indicators, it is typically used as part of a larger trading system. The AO is plotted in its own window at the bottom of a MetaTrader platform and has a zero line much like many other oscillators. The indicator uses the 34 simple moving average and the 5 simple moving average in its calculation. The indicator takes the difference between the two moving averages and plots them in a histogram. The moving averages that are used to calculate the indicator reading aren’t the conventional moving averages that people will use as they don’t measure the close of the candlestick, but the midpoint of the candlestick range. The oscillator is generally used to confirm a trend but can also be used to anticipate a potential reversal of the trend. As an oscillator, it will fluctuate above and below the zero line which is considered neutral. In its standard form, the histogram will print out in red or green bars, with the bar turning green when its value is higher than the one before it. If the bar of the histogram is lower than the one before, it will turn red. When the histogram is above the zero line, it indicates that the shorter moving average is trending higher than the longer one. You can think of this much like a moving average server system. When the values are below the zero line, the short term moving average is lower than the longer one, showing a downtrend. <img alt="" src="/TMXWebsite/media/TMXWebsite/williams_awesome_oscillator_1.png" /> <h2>Adding the indicator to your MetaTrader 4 platform</h2> To add the Awesome Oscillator to your <a href="/metatrader-4">trading platform</a>, you need to click on the ‘Insert’ menu, go down to the ‘Indicators’ submenu, and then select the ‘Bill Williams’ submenu, followed by selecting ‘Awesome Oscillator’. You will notice that the default setting is to have a green bar for ‘Value up’, and a red bar for ‘Value Down.’ You can change these colors but for the purposes of demonstration in this article we will keep them the same. <img alt="" src="/TMXWebsite/media/TMXWebsite/as_2.png" /> <h2>Using the Bill Williams Awesome Indicator</h2> While the indicator is typically part of a larger system, there are a couple of basic ways that it is typically used. The easiest way is to simply wait for the oscillator to cross the zero line. For example, if it’s below and rises above the zero line, it’s considered to be a ‘bullish cross’. On the other hand, if the AO drops below the zero line you can consider it to be a ‘bearish cross’. This adds more confidence to a potential selling position as the underlying moving averages are in congruence and both moving lower. Take a look at the chart below of the four-hour CAD/JPY pair. <img alt="" src="/TMXWebsite/media/TMXWebsite/as_3.png" /> The market breaking down right at the red arrow accompanied by the AO 'bearish cross' gives the trader an opportunity to start selling. You should also pay attention to the fact that once the indicator produced several green candlesticks, the market entered a bit of consolidation and a lot of traders would have taken profits there. Having said that, the indicator tends to work a bit better if you keep in mind the overall trend. For example, when the oscillator went back to form ingrained bars where the trade leveled out, it wasn’t a matter of buying, rather a signal to either get out of the market or tighten up your stop loss.  Take a look at the chart below, as it now has a 50 EMA plotted on it. <img alt="" src="/TMXWebsite/media/TMXWebsite/as_4.png" /> When the signal kicked off at the top of the chart, it was a clear breakdown of that EMA. Furthermore, the EMA was still above price action and turning lower when the oscillator went back to green. By using the indicator to tell you what phase the trend is an, traders could have held on to this position for much further gains. <h2>Divergence</h2> Another way that traders use the Bill Williams Awesome Oscillator is to find divergence. Divergence is when momentum and price aren’t matching. In other words, if price is rising but momentum is falling, that’s a sign that perhaps the underlying momentum and fundamentals of the market are starting to deteriorate. Conversely, if the price is falling but the momentum is becoming more bullish, then it’s possible that the sellers are starting to run out of underlying momentum, meaning they may be likely to flip their position. The Bill Williams Awesome Oscillator works the same way as any other oscillator in this sense. What you are looking for is a peak that doesn’t quite continue the overall momentum of the previous peak, while the price continues. Notice on the chart below the price was rising while the AO was running out of momentum. <img alt="" src="/TMXWebsite/media/TMXWebsite/ad_5.png" /> Notice how the first high was higher than the second one, even though prices continue to drift to the upside. Shortly thereafter, markets broke down a bit, which is the very essence of using divergence for trading. This isn’t necessarily a signal in and of itself, but it tells you that something isn’t quite right. With that in mind, there are a couple of ways to play this. Depending on when you enter the market, the divergence of an oscillator can mean several things. For example, let’s say that you had bought this pair somewhere closer to the bottom, but she started to notice that divergence was showing itself in the oscillator. That’s a warning that you may need to move your stops closer, or perhaps get out of the market altogether. Let’s say that you were in the market, but you started to see divergence. At this point you start looking for an opportunity to sell based upon whatever system you are using. Bear in mind that the price could have just as easily gone sideways after divergence and then picked back up over the longer term. It is yet another signal, not a system in and of itself. Divergence can: <ul> <li>signal a slowing market</li> <li>offer hints as to when you may need to tighten stop losses</li> <li>give the trader an opportunity to look for a reversal signal</li> <li>come and go without major ramifications, meaning that it is only part of the system.</li> </ul> <h2>Final thoughts on the Bill Williams Awesome Oscillator</h2> The Bill Williams Awesome Oscillator is an indicator that is relatively simple to use and isn’t hard to set up. In fact, it will come with any <a href="https://www.thinkmarkets.com/en/trading-platforms/mt5/">MetaTrader platform</a> you are using. It’s important to remember that it isn’t a signal in and of itself. However, what it does do is give you an idea of what a couple of moving averages might look like on your chart without plotting them on your chart itself. Remember, this is simply measuring the difference between the 5 and 34 simple moving averages. In other words, it lets you know when these widen out, and start spreading which for moving average traders suggests that momentum is picking up. The farther away from the zero line the oscillator gets, the more spread out we are and then hence should continue to see momentum. The zero line being crossed itself is simply a function of a moving average crossover. This just means that the moving average has crossed over the other one, just as you would see on a moving average of a system that would be plotted on your chart. In that sense, the oscillator itself is just another take on moving averages overall. This isn’t to dismiss this indicator, it just shows that it is another way to express the overall momentum of the marketplace, something that can be done through a multitude of indicators. It should be noted that price action comes first, and before that even comes into play you should be looking at support and resistance. That being said, if the market does break through a supporter resistance area, the Bill Williams Awesome Oscillator can give you an idea as to whether or not momentum will continue. This is a trend-following indicator, so it is not something to be used in a short-term range bound market. The indicator itself was built by Bill Williams, as we’re sure you have guessed, and has been around for some years. When using the Bill Williams Awesome Oscillator, you should think of it more or less as a tertiary signal, as support and price action should dictate what you do first.

6 min readBeginners

Forex Indicators and patterns

The Bill Williams Alligator Indicator

The Bill Williams Alligator Indicator is a trend-following indicator. As its creator stated, the entire idea of the markets is that they tend to trend between 15% and 30% of the time. Most of the market is grinding sideways in general. Most of the market is grinding sideways in general. The alligator indicator comes built into the <a data-di-id="di-id-3a56e082-fd267adf" href="/metatrader-4/">MetaTrader platform</a>, therefore attracts a lot of attention due to that alone.  This indicator only works in trends, and it should be avoided when you are in a sideways market. It’s based upon the moving averages, so gives you an idea of when a market is trending, therefore it’s relatively easy to see whether or not you should be using the indicator. The indicator is relatively simple to use, so that of course makes it popular as well.  <h2>Adding the Alligator indicator to MetaTrader</h2> It’s very easy to add the indicator to the MetaTrader platform, as it’s already built in. All one has to do is click on Insert, select Indicators, and then follow that with Bill Williams, finally select the Alligator option after that, which will set the indicator active.  Then, you get the Alligator options box, which has several different things that you can change. The basic options include the Jaws period, Teeth period, and the Lips period. You can also choose the Shift variable along with these options. <img alt="" src="/TMXWebsite/media/TMXWebsite/alligator-image-1.jpg" />   Once you click Okay, the indicator then appears on the main price chart. That being the case, you then see the lines appear. There are three moving averages, which are set at 5, 8, and 13.   The indicators are known as the jaw, the teeth, and the lips of the alligator. Although Williams describes this as an alligator, it’s essentially just three moving averages. It’s because of this that it should be relatively simple for most traders to start to use it almost immediately. <h2>What the Alligator indicator tells us</h2> The Alligator Indicator uses the previously mentioned 5, 8, and 13 smoothed moving averages. These are all <a data-di-id="di-id-2479e05d-b9dbef8f" href="/trading-academy/forex/analysis/fibonacci-ratios">Fibonacci numbers</a>, so it makes sense that there will be a certain amount of mystique around the indicator as a lot of traders like the idea of using Fibonacci.    The Jaw is the 13 smoothed moving average, which is smoothed by eight bars on previous values. The Teeth is the 8 smoothed moving average, which is smoothed by five bars on previous values. The Lips features the five bar smoothed moving average, which is smoothed even further by three bars on previous values. This will plot a green (5) moving average, a red (8) moving average, and a blue (13) moving average. <img alt="" src="/TMXWebsite/media/TMXWebsite/alligator-image-2.jpg" />   The indicator looks for convergence/divergence in order to build signals. The Jaw (blue) makes slower turns than the others, while the Lips (green) will be the fastest moving average in the indicator. Because of this, the triple indicators are used very similar to a three moving average server system. For example, if the green indicator slices through the other two to the downside, it's a sell signal. On other hand, if the green indicator slices through the other two to the upside, that’s a bullish sign and a potential buy signal.    Bill Williams suggested that when the downward cross occurred, it was when the alligator was sleeping, while an upward cross is the alligator awakening. It’s probably not that important as to whether or not he calls it one thing or the other, because this will follow a lot of the same rules that a triple moving average crossover system will. After all, that’s all this is but there are some tweaks to the calculations because they are smoothed.    If the three moving averages are stretched apart, that is generally a sign that you are in a trend and should maintain whatever the position is. In the example below, you can see that the moving averages go from being twisted to spread out relatively far at the first red arrow, they compress, and then spread out even further at the second red arrow.    At both of those arrows, the Alligator indicator is letting you know that the market is extremely bearish, and you should be hanging on to short positions. In fact, you can even make an argument for the compression between the two red arrows as not quite enough to get you out of the original position. <img alt="" src="/TMXWebsite/media/TMXWebsite/alligator-image-3.jpg" />   The indicator showing a couple of strong downtrend is the first thing he would notice, but the question then becomes whether or not you are extraordinarily cautious or if you are a little bit more aggressive. In other words, the Lips rising above the Teeth of the indicator, or the green moving average digging into the red moving average between the two arrows could be a sign to start taking profits if you are already short of the currency pair. At this point, it truly comes down to your personal preference, and traders will use both methodologies when it comes to using the Bill Williams Alligator indicator.  According to the description Bill Williams himself uses, there are a couple of ways to describe what’s going on. When the moving averages are short and choppy, then quite often he will describe it as either the market sleeping, or the alligator “being sated.” When the three moving averages start to spread and move in the same direction, then the mouth is opening and the “alligator is starting to eat.” In the chart just below, you can see that there are blue, red, and orange boxes.  In the blue boxes, the moving averages start to spread and rise, which is a very <a data-di-id="di-id-19ae81b6-bdc1b79b" href="https://www.thinkmarkets.com/en/learn-to-trade/indicators-and-patterns/general-patterns/what-is-bullish-and-bearish-divergence/">bullish sign</a>, while the orange boxes show choppy trading conditions with the moving averages, meaning that you are either flat of the market or trying to take profits from your position previously. The red rectangle is the mouth opening for the alligator to eat again, this time driving to the downside. <img alt="" src="/TMXWebsite/media/TMXWebsite/alligator-image-4.jpg" /> <h2>Adding MACD to help the Alligator indicator</h2> Looking at the Alligator indicator, one additional indicator that a lot of traders will use the MACD or Moving Average Convergence Divergence oscillator. This gives traders a “second look” at momentum in the market, right along with price. This setup will operate in the same way that the Moving Average   Convergence Divergence oscillator typically does, meaning that there are a couple of signals that you should be aware of when it comes to using this in addition to the Alligator indicator.  Looking at the chart below, there are several things that you need to be aware of. The MACD crossing above and below the zero line is important. In fact, marked on the chart are several errors to give you an idea as to how you may wish to trade the market by using the Alligator   Indicator and the MACD in concert. Taking a look at the first blue arrow, you can see that the oscillator had crossed the zero line and the histogram in the oscillator started to rise right along with the moving averages of the Alligator Indicator. The next set of arrows are orange, because they show a slowing of momentum. At this point you have the option to either close the trade or perhaps move <a data-di-id="di-id-aaebb41a-956ef5d7" href="https://www.thinkmarkets.com/en/learn-to-trade/intermediate/stop-losses-and-take-profits/">stop losses</a> up a bit closer. Shortly thereafter, there are signs of life again as the Alligator indicator starts to open its jaws again, and the MACD histogram starts to rise.    Closer to the top of the chart you see that there is an orange arrow, as the Alligator Indicator starts the clothes it’s jaw again. Furthermore, the histogram on the oscillator has started to drop, suggesting that perhaps momentum is starting to wane a bit. After that, the red arrow signifies the jaw opening yet again for the alligator to eat, while the MACD histogram is starting to drop much lower and well below the zero line. This suggests that there is quite a bit of downward pressure.  While not marked by arrows on this chart, you can see that the very end of the chart is starting to see the alligator jaws try to close, while the histogram in the MACD is starting to rise, perhaps showing that momentum to the downside is starting to drift a bit lower. <img alt="" src="/TMXWebsite/media/TMXWebsite/alligator-image-5.jpg" />   <h2>Some additional thoughts about the Alligator indicator</h2> The Bill Williams Alligator Indicator is a great trend following type of indicator, but it must be noted that you should be aware of whether or not the market is trending or not. That’s the idea of adding the MACD indicator to the chart, as it can give you a little bit more clarity as to whether or not there is momentum. Having said that, it’s also important to keep in mind that this is simply a triple moving average system.    That being said, one of the biggest concerns about anything involving a moving average is that it's a lagging indicator. In other words, it shows you where price and momentum was, not where it is. With that in mind, the indicator by itself won’t be sufficient enough to have a working system built around it. Granted, it can give you an idea when to get in and out of the market, but it also could cause a lot of choppy results if you are not cautious.    Some things to keep in mind include:    <ul> <li>Bill Williams Alligator Indicator is a lagging indicator</li> <li>It's simply three moving averages</li> <li>The indicator isn’t a system in and of itself and needs help</li> <li>Price action should probably be paid attention to as well</li> <li>The indicator is built into the MetaTrader platform</li> </ul> All things being equal, this is a nice way to find longer-term moves, but it should also be noted that it's probably going to produce better results for you on higher time frames, although that is typically the case with indicators and technical analysis in general. Ultimately, the short-term charts will continue to struggle to use anything related to a moving average, as the price fluctuations on a short time frame can be quite rapid.  Furthermore, it’s probably crucial that you experiment with the idea of whether or not the “alligator being sated” is a reason for you to take profits, or to simply stay out of the market in general. Some traders won’t take profits until the green moving average has crossed all the way through both of the other moving averages, so that is something else to think about as well. In order to figure out what works best for you, it’s important to test in a demo account so that you get familiar with the advent flow of using this indicator.    Candlestick analysis can also be useful, just as it's with any other technical indicator. For example, a hammer or a shooting star may make for a better signal than just a simple spreading of moving averages by itself. A trade setup may be something along the lines of the alligator opening up its jaws again in the Alligator indicator, the MACD showing a zero line crossing with increasing momentum, and a hammer that suggests the buyers are coming back into the market.  In other words, simply following the indicator can lead to a lot of choppy and inconsistent results if you don’t temper it with other help. That’s not necessarily that uncommon when it comes to technical analysis and indicators as most systems use at least a couple of them in order to form buy or sell signals. It’s also important to figure out a timeframe that works best for you, not to mention the fact that some markets will act slightly differently than others. That being said, this is a popular enough indicator that several other traders out there will be following it as well.

6 min readBeginners

Forex Indicators and patterns

How to Use the Stochastic Oscillator

One of the most basic and perhaps oldest indicators used by technical analysts is the stochastic oscillator. The stochastic oscillator is an indicator that measures momentum and the strength of a trend. Essentially, its job is to analyse price movement and show how strong the price move is.    The indicator measures the momentum of price, and also shows a slowing of momentum as the momentum of a financial instrument needs to slow down before changing direction. This addresses a weakness in retail trading, the fact that far too few traders pay attention to the importance of the rate of change.    The stochastic oscillator is one of the more common indicators, and it’s one that you will see in a lot of analysis. However, like any other indicator it is simply a tool that you will be using to navigate through the forex markets, and like any other tool it is needed to be used in the proper settings and situations.  <h2>How to add the stochastic oscillator to MetaTrader charts</h2> Adding the stochastic oscillator to the MetaTrader platform is very easy. By clicking on the Insert menu, you can pull down the list and click on Indicators, followed by Oscillators, and then Stochastic Oscillator. It's a common indicator, and as such it's built into the platform and there is no need to download from anywhere else. <img alt="" src="/TMXWebsite/media/TMXWebsite/Oscillator-picture-1.jpg" /> The settings dialog box will pop up, and there are multiple parameters that you can change. The %K period and the %D period settings are available. The %K should be thought of as the slow value of the stochastic indicator and the %D should be thought of as the fast value of the stochastic indicator. It uses a couple of moving averages to measure the overall momentum. <h2>Why does momentum matter?</h2> Think back to your mathematics studies. One of the biggest influences in calculus is the absolute rate of change. The idea is that if the market is in an uptrend, but if the momentum starts to slow down, it can suggest that the market is running out of steam and, therefore, could be ripe for a reversal. In this sense, it can suggest whether or not the market is going to continue, or if it might be over-extended in one direction or the other, and other words overbought or oversold. <h2>Using the indicator to make decisions</h2> The stochastic oscillator has a multitude of uses when it comes to trading forex. We have already mentioned the most obvious use for the stochastic oscillator: the idea of identifying overbought or oversold conditions. In this scenario, the stochastic oscillator is best used in a range bound market, as it can tell you when to buy and sell in a relatively well defined situation. When you look at the stochastic oscillator window at the bottom of the chart, you see the two moving averages going back and forth in an up and down pattern. You will notice that there are two lines in the indicator window including the 80 and the 20 level.   The area above the 80 level is considered to be overbought, while the area below the 20 level is considered to be oversold. Furthermore, you need to see the moving averages inside the stochastic oscillator to cross in the overbought or oversold areas in order to get a reversal signal. Anything between the two levels is essentially ignored in this scenario. <img alt="" src="/TMXWebsite/media/TMXWebsite/Oscillator-picture-2.jpg" />   Looking at the chart, you can see that the stochastic oscillator had several moves back and forth between the 80 and the 20 levels. However, there are only a couple of areas where the indicator either broke into the overbought area or the oversold area and had a cross. You need both of these things to happen in order for it to fire off a signal.   In the graphic below, you can see that the signals fired off are color-coded by the arrows, with the red showing an overbought condition and a potential selling opportunity, and the blue showing potential buying opportunities in an oversold condition.   It should be noted that using the stochastic oscillator in this way is much more reliable when in a sideways market, preferably between significant support and resistance. This makes the stochastic oscillator truly important, because statistically speaking markets are in some type of consolidation or sideways action more than 70% of the time. In other words, it’s much more common to be in this environment than it is to be out of it.  <h2>Measuring divergence</h2> Another way that people use the stochastic oscillator in forex trading is to measure for divergence. The idea is that as with any oscillator, you could see momentum going in a different direction than the overall price. As an example, the momentum could be rising while price is falling or vice versa. If you are in a scenario where price is rising but the momentum is slowing, that means that there is less aggression to the upside and therefore less demand, even as prices press higher. This can be a sign that potential trouble is on its way.    Take a look at the chart just below. You can see that there is a clear uptrend line on the four hour chart for the GBP/AUD pair. As the price was rising, though, notice that the stochastic oscillator made a lower high, which is the opposite of an uptrend. This suggests that the rate of change is slowing down, therefore one would have to be a bit suspicious about the efficacy of the move.    After all, if there is less momentum, it suggests that there are fewer fresh orders coming in to push the market to the upside. Ultimately, you can see that shortly after the diversions with the lower high in the stochastic oscillator, the market broke down below the trend line and then eventually fell from those levels. Divergence can be found in several indicators, essentially the oscillator family. Because of this, using your divergence spotting skills can work in multiple other oscillators as well, as they all essentially work the same in this scenario. <img alt="" src="/TMXWebsite/media/TMXWebsite/Oscillator-pic-3.jpg" />

6 min readBeginners

Forex Indicators and patterns

How does the Money Flow Index (MFI) indicator work?

If you are looking to find the demand for a financial asset, you need to be able to track monetary flows in and out of the markets. The Money Flow Index (MFI) indicator is used to measure supply and demand, which is usually the simplest way to determine where a market may be going. Note that this indicator was initially designed to work with the stock markets, as forex markets are not centralised, and therefore some of the inputs will be different to the original scenarios many traders had been using in equities. The basic premise is that if demand for a particular currency is high but supply is limited, prices will rise as bidding increases. This is the same as any other bidding process: if there are more people wanting to own something, people will try to outbid each other. Of course, the opposite is true as well: when demand drops, sellers have to drop prices to attract buyers. The Money Flow Index indicator is a popular method of viewing how these forces interact with the markets. <h2>The calculation</h2> The indicator uses a couple of different mathematical equations in order to find where the market may be ready to go. The equation seeks to find the ‘Typical Price’ by determining in the mean of the high, the low, and the closing prices for the time period in question. In mathematical notation: TP = (H+L+C) / 3 I.e. the Typical Price equals the high, low, and close divided by three. The next part of the calculation takes in what is known as money flow. This takes the typical price and then multiplies it by volume. There’s no way to know in a non-centralised market exactly how much volume is being done, but by using the volume at your broker, you get a fair representation of what the larger market should be. The next equation: MF = TP x V Or, Money Flow equals Typical Price multiplied by Volume. The next part of the calculation looks at positive and negative flows over the quantity of periods that the indicator is set towards, known as money ratio. The indicator defines positive money flow as being any candle where the Typical Price is higher than the previous candle. Conversely, negative money flow is when any candle has TP lower than the previous candle. To get the positive money flow for the indicator, the calculation is to add up the total positive money flows over the time span in question. Ultimately, to get the negative money flow for the indicator, the calculation is of course to add up the total negative money flows over the same time span. The equation is: MR = positive money flow / negative money flow. Finally, everything is converted into an index using the following mathematical formula:   MFI = 100 - 100 / (1 + MR) In other words, the Monetary Flow Index is a ratio of positive money flow into an asset compared to the total money flow. The indicator of course shows this for you, and you don’t have to do the math behind it, as it is built into the <a data-di-id="di-id-8ed17442-be85d085" href="/metatrader-4/">MetaTrader 4 platform</a>.  The default measurement is 14, meaning that if you are looking at a daily chart, the Money Flow Index is giving you a reading of the last 14 days. If it is on the hourly chart, it is reading the last 14 hours, and so on. <h2>How to attach the Money Flow Index indicator</h2> To use the Money Flow Index indicator on the MetaTrader 4 or 5 platform, go to the 'Insert' menu then go to the 'Indicators' submenu, followed by the 'Volumes' submenu, and selecting 'Money Flow Index'.  The indicator will show up in its own window at the bottom of your platform. <img alt="" src="/TMXWebsite/media/TMXWebsite/money_flow_index_001.png" /> At this point, you can start to look for opportunities using the Money Flow Index. Using the indicator  The MFI indicator is used to indicate when a market is overbought or oversold. In the indicator, you will notice there are two levels marked by dashed lines of 20 and 80, with the absolute highs at the 100 level, and the absolute lows are 0. When the line is above 90, the market is possibly overbought. Conversely, the indicator moving below the 20 level suggests that the market is oversold. Let’s look at the chart below. The red arrow points out where the indicator has broken above the 80 level, suggesting an overbought condition. Shortly afterwards, the EUR/GBP pair dropped. After that, you can see there was a bounce where the blue arrow marks the Money Flow Index dropping below 20. While there is just a short term bounce, there is a bounce, nonetheless. This can often be filtered by something along the lines of a moving average, or even a trendline. <img alt="" src="/TMXWebsite/media/TMXWebsite/mfi_002.png" /> To summarise: <ul> <li>The 80 level is where a market enters an “overbought” condition</li> <li>The 20 level is where a market enters an “oversold” condition</li> <li>The indicator is built into the MetaTrader 4/5 platforms, as well as many others</li> <li>The default reading will be for the last 14 candles, but can be changed</li> <li>The Money Flow Index is often used with other indicators as well</li> </ul>   <h2>Adding an additional filter </h2> Many traders choose to compliment the MFI indicator with a moving average. This is because the moving average can keep you on the right side of a trend. If you are looking for an indication of an overbought or oversold condition within the Money Flow Index indicator, this can be validated by a move above or below a moving average. Let’s look at the below four-hour chart in the Canadian dollar/Japanese yen currency pair. <img alt="" src="/TMXWebsite/media/TMXWebsite/mfi_003.png" /> The blue arrow indicates where the Money Flow Index indicator reached the oversold condition. Shortly after that, the price crossed above the 20 exponential moving average, one that is commonly used. The way to think about this move is that the market had gotten oversold, and then by breaking above a common moving average, it shows that the momentum and trend is starting to change to the upside. At that point, most traders would enter a position. Later on, in the same chart, you can see that the Money Flow Index indicator had entered the overbought condition, and the price shortly thereafter fell below the 20 EMA. That tells you that the shift is starting to gain momentum, and the market starts to fall from there. Ultimately, this keeps you in the loop when it comes to a potential trend change, and then gives you confirmation in a one-two set up. In another example, we can apply the Bollinger Band indicator to the chart, looking for signs of oversold or overbought conditions from both indicators. <img alt="" src="/TMXWebsite/media/TMXWebsite/mfi_004.png" /> Looking at the chart, you can see where the blue arrows start that the market has broken below the oversold level, followed very quickly by the market breaking below the bottom of the Bollinger Band indicator. This shows that the market is oversold as far as the Money Flow Index indicator is concerned, but more importantly it is also oversold with both indicators. By breaking the bottom of the Bollinger Band indicator, it now is two standard deviations below its average price. With both of these indicators you have the ability to see a slowdown in volume going into the market, and at the same time you can see that the market is statistically farther away from normalcy than it should be. This almost always sets up for a ‘reversion to the mean’, demonstrated by the moving average in the middle of the Bollinger Band indicator. However, some people will also aim for the top of the indicator: it boils down to your own personal trading style.

6 min readBeginners

Forex Indicators and patterns

Triple Top Candlestick Pattern Trading Strategy

The triple top is a bearish candlestick pattern that occurs at the end of an uptrend. As a reversal pattern, the triple top formation suggests a likely change in the trend direction, after the buyers failed to clear the horizontal resistance in three consecutive attempts, the scenario opposite of the triple bottom pattern.   In this blog post, we look at the structure of the triple top chart pattern and what the market tells us through this formation. We are also sharing tips on the simple triple top trading strategy that will help you make profits.  <h2> What the pattern tells us </h2> The triple top pattern is quite a straightforward formation. It consists of three consecutive highs/tops recorded at, or near, the same level. For this chart pattern to take place in the first place, the price action has to trade in a clear uptrend. Given that it requires three peaks to be created, it’s almost impossible to find a perfect triple top pattern where both the horizontal resistance and the neckline are perfectly horizontal. Therefore, allow some space for a neckline to be bent, or one of the peaks printing mostly below or above the horizontal resistance.  These are the three mandatory elements for the triple top pattern to take place: <ul> <li>An uptrend - the asset’s price must trade higher in a series of the higher highs and higher lows.</li> <li>Horizontal resistance - a trend line connecting three roughly equal highs.</li> <li>A neckline - a trend line that connects lows in between three peaks, and whose break signals the activation of the formation.</li> </ul>   <img alt="a triple top chart pattern illustration" src="/TMXWebsite/media/TMXWebsite/Triple-Top-Image-1.jpg" />   The occurrence of the triple top pattern signals a strong uptrend. The bulls must have been in a really positive momentum when one found enough power and strength to test the horizontal resistance three times in a row. In most cases, the price action reverses after the second failure. Therefore, the triple top pattern is used as a tool to change the trend direction. The buyers had been long in control, making gains in an uptrend. After a period of the bulls’ dominance, which is likely to end after the three failed attempts to clear resistance, the sellers start growing in the game, threatening to reverse a trend of the price action.  After the third unsuccessful failed attempt to break the resistance, the probability of the neckline break increases. Once it occurs, the triple top pattern is activated. For this reason, the neckline is arguably the most important element of the triple top pattern, as its break activates the pattern and then helps us determine the stop loss and take profit levels.  <h2>Strengths and weaknesses</h2> Due to its design, the triple top pattern is a rare, but a very powerful pattern. The fact that the buyers failed in as many as three successive attempts to break higher makes the reversal extremely powerful. These failures make them feel exhausted and vulnerable, which presents an opportunity to sellers to erase earlier gains of the opposite side.  The triple top pattern occurs less frequently than the double top, as there is one peak less to happen. It also reduces the chances of a breakout as the buyers are left with no energy after the third failure.  On the other hand, the fact that it is a rare chart formation is also its biggest weakness. For instance, you would need to spend some time on a chart before you can identify a clean triple top pattern that meets all the required criteria. <h2>Spotting the triple top pattern</h2> Remember, the triple top is a bearish reversal pattern that stems from an uptrend. In the chart below, we have a USD/CAD on a 4H chart moving aggressively higher on the left side of the chart. The price action then hits a $1.29 horizontal resistance and fails to clear it, causing the first bigger correction since the trend was initiated. The buyers use this correction to regroup and regain confidence and launch another assault at the same level, but again without much success. What follows are multiple attempts to get to the $1.29 level again, with choppy action recorded in the $1.28s, just before the third peak. After another correction lower, the buyers press the price action once again, trading briefly above $1.2910 and then correcting lower.   <img alt="USD/CAD H4 chart - Spotting the triple top pattern" src="/TMXWebsite/media/TMXWebsite/Triple-Top-Image-2.jpg" /> This example shows how powerful triple tops could prove to be. In addition to multiple attempts to clear this resistance, the third attempt resulted in a bearish <a href="/en/trading-academy/forex/japanese-candlesticks">candlestick pattern</a><a href="/en/trading-academy/forex/japanese-candlesticks"> </a>that just invited additional selling pressure. All these failures were simply too much to handle for the bulls, who finally gave up and let the bears erase all previous gains in a quick manner.   It is really difficult to wait for the perfect triple top pattern. They are rare, and even when identified, you have to leave some space for certain deficiencies to be present e.g. a bent neckline or unequal highs/peaks. <h2>Trading the triple top pattern</h2> All in all, we take a note of the three mandatory elements of the triple top pattern - an uptrend, three failures, and a break of the neckline that activated the pattern and opened the door for us to get into the market.  As with every other candlestick pattern, there are two options for an entry:    <ol> <li> after the breakout candle closes below the neckline </li> <li> waiting for a retest of the broken neckline. </li> </ol> In this particular example, both options are eventually on the table. For whichever of these two you would have chosen, your entry would have been the same. The stop-loss order is placed above the neckline, allowing some space for a potential retest of the neckline from a downside. <img alt="USD/JPY H4 chart - Trading the triple top pattern" src="/TMXWebsite/media/TMXWebsite/Triple-Top-Image-3.jpg" />  The vertical blue measures the distance between the neckline and the horizontal resistance. A simple copy-paste from the point of a breakout gives you a measured take-profit level, which if hit, marks the completion of the triple top pattern.  As you can see from the chart, the price action first came close to hitting the take profit, but reversed and returned higher for a retest of the neckline. Finally, our profit-taking level has been hit, booking us more than 280 pips. On the other hand, we risked just 30 pips, hence making this setup a perfect trade from the risk-reward perspective.

6 min readBeginners

Forex Indicators and patterns

The ascending triangle candlestick chart pattern

The ascending triangle is a bullish candlestick chart pattern that occurs in a mid-trend and signals a likely continuation of the overall trend. It’s one of the most common chart patterns as it’s quite easy to form - consisting of two simple trend lines.  The price action temporarily pauses the uptrend as buyers are consolidating. This pause is marked with higher lows pushing for a breakout to the upside, which then activates the pattern. In this blog post we will discuss how the ascending triangle is formed, what the message that the market sends is, and share tips on a simple but effective trading strategy based on ascending triangles. <h2>What the ascending triangle shows us</h2> The ascending trend line chart pattern is a bullish formation. It signals that the market is consolidating after an uptrend, with the buyers still in control. The occurrence of the higher lows is pointing toward a likely breakout as the wedge narrows down.   <img alt="ascending triangle - an illustration" src="/TMXWebsite/media/TMXWebsite/the-Ascending-Triangle-pattern-pic-1.jpg" />     There are three key features of an ascending triangle:   <ul> <li>Strong trend - In order for the ascending triangle to exist in the first place, the price action must stem from a clear uptrend;</li> <li>Temporary pause - This element refers to the consolidation phase, which will help the buyers consolidate their strength;</li> <li>Breakout - The break of the upper flat line marks the breakout, which activates the pattern. It also helps us determine the entry, take profit, and stop loss at a later stage.</li> </ul> Bullish continuation patterns can assume different forms - triangles, flags, pennants etc. The ascending triangle is one of the most common formations in this area, as it practically consists of two converging trend lines.  As a continuation pattern, the ascending triangle is based on the idea that the likelihood of the trend continuing in the same direction is higher than the chance of a reversal taking place. The bulls are in full control of the price action, as they have been successful in pushing the market higher.  At one point, the consolidation phase starts, which gives the buyers breathing space as they regroup for another push higher. These temporary pauses can take different forms, with the ascending triangle being one of them.  From this perspective, it’s logical that the side that has been in control so far has a higher chance of winning the upcoming matches than the side that has been on the losing side. The period of consolidation ends once there is a confirmed breakout in the direction of a previous trend. <h2>Strengths and weaknesses</h2> As outlined earlier, the continuation of an uptrend takes a specific form. This form, in this case the ascending triangle, helps us define the trading environment. On one hand, a break of the upper trend line signals the continuation of the bullish trend.  On the other, a move below the supporting line breaks the series of the higher highs and invalidates the entire pattern. In this case, the followup is usually a strong move lower as the buyers missed their chance to continue the uptrend.  Thus, this is the main strength of the ascending triangle - it helps the uptrend to extend. Due to the existence of two trend lines, we are in a better position to determine the take profit and stop loss, if the pattern is activated.   The biggest limitation of the bullish triangle, as it’s the case with other types of triangle, is a false breakout. The price action may move above the resistance line, just to return below, and hit a stop loss. In order to minimise the chance of a failed breakout, it’s always advised to consult other technical indicators and confirm the breakout e.g. volume, RSI etc.   Moreover, consolidation of power takes place as the two lines converge. The narrower the wedge gets, the stronger the breakout usually is. Hence, this amount of power and strength can’t always be controlled, and therefore, it may end up in the price exploding in the opposite direction, although the chances of a continuation of the existing trend are always higher. <h2>Spotting the ascending triangle</h2> As said earlier, the ascending triangle is a bullish formation that occurs in a mid-trend. In the chart below, we can see how the ascending triangle looks in the live market. From an existing uptrend, the price action extends higher through the bullish triangle.  Two trend lines are drawn to connect the highs and lows, with the latter closing in on the former. When the two lines get closer to one another, the likelihood of a breakout increases. Finally, the USD/CHF buyers are able to push the market outside of the consolidation phase in a clear and strong breakout.   <img alt="the ascending triangle on USD/CHF hourly chart" src="/TMXWebsite/media/TMXWebsite/the-Ascending-Triangle-pattern-pic-2.jpg" /> As you can see in the chart above, the upper line is not exactly flat. In general, it’s extremely rare to see the upper trend line completely flat, as we will almost always see mild bias toward one or the other side. As long as the resistance line is close to being a flat one, it’s generally acceptable. <h2>Trading the ascending triangle</h2> Using the same example, we will now showcase how to trade the ascending triangle. As soon as there is a breakout, which is confirmed with a close above the resistance line, we may consider entering the market on the long side. As with every <a href="/en/trading-academy/forex/japanese-candlesticks">candlestick pattern</a>, we have two options for the entry - immediately after the breakout candle closes, or waiting for a potential throwback. The black horizontal line reflects our entry position - the breakout H1 candle close. The stop loss is placed within a triangle, as any move below the upper line will invalidate the pattern. As always, make sure you leave some space to allow for a potential retest of the broken trend line.    <img alt="trading the ascending triangle on USD/CHF hourly chart" src="/TMXWebsite/media/TMXWebsite/the-ascending-triangle-pattern-pic-3.jpg" />   The blue vertical trend line is a copy of the distance when the triangle was first formed - when two trend lines were identified. The upper end of the trend line tells us where we should consider taking our profits off the table i.e. where the ascending triangle pattern is completed.  In the end, the market completed the bullish triangle formation and rotated lower. This example shows how profitable ascending triangles can be, as we risked 15 pips to make nearly 100 pips - a R:R ratio of more than 1:6. Remember, the ascending triangle helps us format the price action and identify trade details - entry, stop loss, and take profit.

6 min readBeginners

Forex Indicators and patterns

How to Trade the Bull Pennant Pattern

The bull pennant is a bullish continuation pattern that signals the extension of the uptrend after the period of consolidation is over.   Unlike the flag where the price action consolidates within the two parallel lines, the pennant uses two converging lines for consolidation until the breakout occurs.  As you will see from our example below, trading the pennants is a very similar process to trading flags. In this blog post we look at what a bull pennant is, its structure, strengths and weaknesses. At a later stage we will also share tips on how to trade a bull pennant and make profit.  <h2>What the bull pennant shows us</h2> The bullish pennant is very similar to a bullish flag. Both consist of two phases: a strong uptrend and consolidation. However, the latter phase takes the form of a wedge or triangle in the case of the pennant, unlike the flag where we have a channel.  The consolidation phase must stem from an uptrend, otherwise it’s just a normal triangle. Hence, the move higher is classified as flagpole, with a pennant coming on top of it.  Following the establishment of a short-term peak, the price action starts to consolidate below the highs. Two converging lines connect the higher lows and the lower highs, until these two intersect. In this case, the breakout must take place, unlike the bull flag where the consolidation within the two parallel lines can take much longer.   <img alt="Bullish pennant - an illustration" src="/TMXWebsite/media/TMXWebsite/Bull-Pennant-image-1.jpg" />   Similar to flags, both the bull and bear pennants consist of three main elements:    <ul> <li>The flagpole - the asset’s price must trade higher in a series of the higher highs and higher lows;</li> <li>Pennant - a consolidation phase takes place between the two converging lines;</li> <li>A breakout - a break of the upper trend line activates the pattern, while a break of the supporting line invalidates the formation.</li> </ul> As not one market move happens in a straight vertical fashion, the dominating side must play a tactical game and take breaks between the aggressive moves. Hence, the buyers want to consolidate their recent gains and allow for a minor correction lower. After a temporary pause, the price tends to breakout in an explosive manner.  Similar to a bull flag, the consolidation phase shouldn’t surpass the 50% <a data-di-id="di-id-5e4c19cf-b9dbef8f" href="/en/trading-academy/forex/analysis-fibonacci-ratios">Fibonacci retracement</a> of the prior leg higher (the flagpole). A pullback that extends below 50% signals that the uptrend is not as strong as it should be. Hence, a strong bull pennant corrects to around 38.2% before breaking the upper trend line. <h2>Strengths and weaknesses</h2> The bullish pennant is a continuation pattern as it tends to help the existing uptrend extend higher. In essence, the pennant helps traders identify the stage at which the trend is currently in. Therefore, it is much easier to trade the pennant, as trading levels are precisely defined by the two converging lines and a flagpole. A formation that checks all three boxes (flagpole, a pennant, and a breakout) with a correction ending at around 38.2% is a textbook bullish pennant pattern. The shorter and milder the correction, the stronger the uptrend and the ultimate breakout usually is.  Pennants share the same weakness with flags, as the prolonged consolidation phase can result in a reversal pattern. For this reason, it is important not to enter the trade before the breakout occurs and to always consult other technical indicators in confirming the breakout. <h2>Spotting the bull pennant pattern</h2> As a continuation pattern, the key in spotting the bull pennant lies in identifying a clean uptrend first. The uptrend is defined as a series of the higher highs and higher lows. If the consolidation then takes the form of a pennant, we must be ready to dip into the market as soon as the breakout occurs.  We see one example in the EUR/USD hourly chart below. The buyers are forcing the price movements higher in a very aggressive manner. After the short-term peak is in place, the price action starts correcting mildly lower. You can see that the form of this correction is triangular, meaning that EUR/USD created a few lower highs and higher lows.   <img alt="Spotting the bull pennant pattern" src="/TMXWebsite/media/TMXWebsite/Bull-Pennant-image-2.jpg" />   This is a textbook bull pennant chart formation. As the uptrend is strong, the temporary pause is rather short and the bulls are full of confidence and eager to extend the trend higher.   Just a few hours after the consolidation had started, it actually ended with a powerful bullish candle that burst through the upper line. <h2>Trading the bull pennant pattern</h2> We noted earlier that a trader is advised to wait for a breakout to take place before entering the long trade. This is advised to protect yourself from a potential reversal, as consolidation may result in the change of a trend direction, rather than a continuation. Hence, the pennant chart pattern is in “draft” mode until the breakout takes place.    <img alt="trading the bull pennant pattern" src="/TMXWebsite/media/TMXWebsite/Bull-Pennant-image-3.jpg" />   As is the case with all candlestick chart patterns, we have two options for an entry. You can open a trade as soon as the breakout candle closes above the upper line of the pennant i.e. the close is confirmed. Contrary, you can eventually opt to wait for a throwback, when the price action returns to the “crime scene” to retest the broken pennant.  The latter offers a great risk-reward since the entry is at a lower price and the stop loss is very close to the entry, hence, you are risking very few pips. The former makes sure that you don’t miss out on a trade as there are no guarantees that a throwback may take place at all.  As you can see from the EUR/USD chart above, the throwback never took place, which is not surprising given the overall strength of the initial uptrend. The buyers simply forced a breakout and never looked back. As a matter of fact, they created ten consecutive bullish candles on an hourly chart.    The first option is more secure and we take it. The entry is placed at a price where the breakout closes, while <a data-di-id="di-id-5178dce0-956ef5d7" href="/en/trading-academy/cfds/risk-management-tools-in-cfd-trading">the stop loss</a> is located just below the breakout candle and the wedge. In general, the stop loss is located below the upper line - the resistance - however, the triangle in this case is very narrow as two trend lines have almost intersected when the breakout took place.  Take profit is defined by copy-pasting the flagpole, from a point of the breakout (the diagonal trend line). The end point of the trend line signals a level where the bull pennant pattern is completed. A couple of hours since we entered the trade, our take profit order is activated. We completed a trade with a gain of 120 pips, compared to the 30 pips that we risked, which translates into a phenomenal 1:4 risk-reward ratio.

6 min readBeginners

Forex Indicators and patterns

A guide to trading the head and shoulders pattern

The head and shoulders pattern, as well as the inverse head and shoulders formation, are two of the most popular trading formations. Although they are not so easy to identify, they are very reliable and effective patterns that offer extremely lucrative risk-reward opportunities.  In this blog post, we are looking at the structure of the head and shoulders and inverse head and shoulders patterns, how to correctly draw them on the chart  as well as their most effective use case. Moreover, we will be sharing tips on how to trade and make profit by trading the head and shoulders and inverse head and shoulders formations.  <h2>Spotting the head and shoulders pattern</h2> The head and shoulders pattern is arguably the most popular reversal pattern among traders. It's called head and shoulders formation because it resembles a baseline with three peaks, with the centre peak being the highest out of the three. As such, the three tops look like a ‘left shoulder’, ‘head’, and a ‘right shoulder’. Both the traditional formation - head and shoulders - and the inverse head and shoulders formations are reversal patterns. Both consist of three mandatory elements:   <ol> <li> Head - This is the highest (traditional formation) or the lowest (inverse version) peak of the formation. In both versions, the head should be at a higher/lower level compared to the two peaks on each of the sides.  </li> <li> Shoulders - Two tops sitting on both sides of the centre peak are called left and right shoulders. Ideally, they should be symmetrical i.e. at the same or near the same price level. As these are extremely difficult to identify, asymmetrical shoulders are also widely accepted, as long as the distance in two peaks is not huge.  </li> <li> Neckline - A trend line that connects bottoms of the two shoulders is called a neckline. It's arguably the most important feature of the pattern as its break activates the pattern.  </li> </ol>   The key difference between the traditional version and the inverse formation is that they occur at the opposite sides of the chart. A head and shoulders pattern is a bearish reversal pattern, which signals that the uptrend has peaked, and the reversal has started as the series of the higher highs (the first and second peak) is broken with the third peak, which is lower than the second. <img alt="" src="/TMXWebsite/media/TMXWebsite/traditional-head-and-shoulders-pattern.jpg" />   As you can see in the picture above, the traditional formation starts in an uptrend and ends in a downtrend. As such, head and shoulders signals a top (the second peak) of the current uptrend. A break of the neckline activates the pattern and makes the entire setup tradeable.  On the other hand, the inverse head and shoulders is a bullish reversal pattern that occurs at the end of a downtrend. The sellers have run out of gas as they were unable to continue the series of the lower lows. The third low (the right shoulder) is at a higher level than the previous peak.  <img alt="" src="/TMXWebsite/media/TMXWebsite/Inverse-head-and-shoulders-pattern.jpg" /> After the creation of a first peak (the left shoulder), the price action rebounds modestly before continuing lower to create a lower low (the head). The price then again rebounds to a level similar to where the first rebound was finished, creating a base for the neckline to be drawn.  What follows is another pullback to create a third low (the right shoulder), before the price action finally bursts higher, breaking the neckline resistance, and activating the inverse head and shoulders pattern.    <h2>Strengths and weaknesses</h2> Both versions of the pattern share the same strengths and weaknesses, as they only differ in the context of structure. Arguably, the greatest advantage of the head and shoulders pattern is that it defines clear areas to set risk levels and profit targets.  Due to its design, the pattern offers a clearly defined<a href="https://www.thinkmarkets.com/en/learn-to-trade/intermediate/stop-losses-and-take-profits/"> stop loss, take profit,</a> and entry levels. A trader should only follow the set of rules (described below) and make sure that they don’t “jump the gun” and enter a trade before the neckline is broken.  It's extremely important to stress that both the inverse and the traditional head and shoulders patterns only occur at the bottom of an uptrend or downtrend. This is a common mistake traders and analysts make. It doesn’t matter that you drew a perfect head and shoulders pattern, if there is no prior uptrend or downtrend as both versions are reversal patterns.    The key limitation of the head and shoulders pattern is that a strong trend sometimes causes the price action to continue in the same direction despite the third peak/low being a lower high or higher bottom. In this case, the head and shoulders, or inverse head and shoulders, are seen as continuation patterns as the prevailing trend has resumed after taking a short break. <h2 dir="ltr">Drawing the pattern</h2> Unlike some other chart patterns, trading the success of the head and shoulder formation rests very much on how well you draw the initial pattern. As outlined earlier, this pattern offers a set of predefined levels, as you are actually trading against the neckline. Thus, drawing the pattern and identifying three key elements is the crucial part of the entire trading process.  The daily chart of USD/CAD shows a head and shoulders pattern that helps reverse the direction of a trend. The price action pushes higher, creating three consecutive peaks with the right shoulder slightly lower than the left shoulder. Still, there are two clear peaks on each side of the centre peak, with a slightly ascending trend line connecting two shoulders.  <img alt="" src="/TMXWebsite/media/TMXWebsite/head-and-shoulders-pic-3.jpg" /> You can see that we started in an aggressive uptrend and finished the pattern in a downtrend, with the bears ultimately erasing more than half of the earlier gains. A similar situation occurs with the inverse head and shoulders pattern lower. This is a NZD/USD daily chart where the sellers are pressing the price lower, creating a series of lows. The head is represented by a series of similar lows, while the two shoulders are sitting on each side of the head. Although the head usually consists of a single peak/low, we can also have rounded lows or peaks, as long as there are shoulders visible on each side of the head. <img alt="" src="/TMXWebsite/media/TMXWebsite/head-and-shoulders-pic-4.jpg" /> You can see that the NZD/USD pair creates a new short term low (the lowest low of the head) before pushing higher to create a series of the higher lows before eventually surging higher above the neckline.    <h2>Trading the head and shoulders pattern</h2> We stated earlier that possibly the greatest advantage of this formation is that it offers precisely defined levels. The key is a neckline due to the three reasons:   <ol> <li>A break of the neckline activates the pattern. Before the neckline is broken, we consider the pattern to still be in the making. </li> <li>A neckline defines the stop loss i.e. after the breakout, any reverse move to the other side of the neckline activates the stop loss and automatically invalidates the pattern. </li> <li>A distance between the neckline and the head is measured to calculate the take profit. </li> </ol>   We will now use the same two examples to give you a step-by-step guide on how to trade the head and shoulders and inverse head and shoulders patterns. Once we have drawn the pattern and identified three key elements of the formation, we monitor the “draft” pattern closely and wait for the bears to potentially break the neckline and activate the formation. There are two options for the head and shoulders pattern as far as the entry is concerned.  <img alt="" src="/TMXWebsite/media/TMXWebsite/head-and-shoulders-pic-5.jpg" />   The first option offers you a chance to enter a short trade as soon as the neckline is broken and the daily candle closes below the broken neckline. This option means that you can’t miss a trade.  However, this one is also riskier as this move lower can easily prove to be a failed breakdown. In this case, your stop-loss would be activated almost instantly.  The second option is prefered by the majority of the trading community. It's based on an idea that you should make an entry after the price action closes below the neckline and the breakdown is confirmed. Accordingly, the buyers will then push the price action to retest the neckline, the so-called “throwback”, before resuming lower. Thus, you should place the entry when the throwback occurs. Of course, the price action can still return above the neckline, however, the chances are smaller than with the first option. The limitation of the second option is that the price action can simply resume lower without performing a throwback i.e. a retest of the neckline is not guaranteed (see example 2 lower). USD/CAD closed below the neckline on a daily basis, then the buyers pushed the price higher the next day, before ultimately sliding lower. From the risk-reward perspective, this is a perfect scenario as you are given the opportunity to enter a trade on the retest.  Wherever you decided to place the entry, the stop-loss should be located above the neckline. You are advised to always allow for a cushion between the stop-loss and a neckline. As you can see in our example, the buyers were able to trade briefly above the neckline before getting rejected.  The take profit is calculated by measuring the distance between the head and a neckline (the green line), and then copy-pasting the same trend line starting from the neckline and extending lower. This way, you define the exact point at which the head and shoulders pattern should be completed.    Finally, our entry is at $1.2820, stop loss around $1.2860, while a take profit order is set at $1.2550. Hence, we risked 40 pips to make 270 pips, which is a phenomenal risk-reward ratio and the best evidence as to why the head and shoulders is such an effective reversal pattern.    We now move to our second example by explaining how to trade the inverse head and shoulders. In essence, we follow the same set of rules. Once we have drawn all the key elements, we are waiting for the NZD bulls to push the price higher. <img alt="" src="/TMXWebsite/media/TMXWebsite/head-and-shoulders-pic-6.jpg" /> Earlier we discussed two options available to set your entry. This example belongs to the second option and it perfectly shows why this is a riskier option. As you can see, the bulls never returned to retest the broken neckline once the breakout occured. Hence, if you had opted to wait for a retest, you’d have missed the trade.  By choosing the first option, you’d enter a trade once the daily close above the neckline has been secured. The stop loss is again placed below the neckline, while the blue line measures the distance for a take profit order. A few weeks later, the inverse head and shoulders pattern is completed. In this case, we risked 70 pips to gain around 200 pips, which makes a nearly 1:3 risk-reward ratio, meaning this was a very good setup from the risk tolerance perspective.

6 min readBeginners