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Another Failed Head & Shoulders – Time To Retire The Pattern?

Hello there Price Action Traders,

Yet another Head and Shoulders pattern has resulted in a loss for me.

Check out this weekly Head and Shoulders pattern on EURGBP that I’ve been watching lately:

head_and_shoulders 1-min

A clear left shoulder, an obvious head, and a nice right hand shoulder.

Textbook.

Then, we get a clean break of the neckline, and a close below.

Pretty much perfect. If there was ever a Head and Shoulders trading set-up that should be plain sailing, this would be it.

But then this happened:

head_and_shoulders2-min

What’s going on?

Well, I’ve been looking into it, and I’ve noticed that Head and Shoulders patterns have been getting a hard time recently. I came across an article from Anora Mahmudova on Marketwatch.

The title is: “Don’t Look Like A Dummy, Dump These Invalid Chart Patterns

She wants us to dump these silly, invalid, antiquated chart patterns. She then shows us an example of a failed Head and Shoulders pattern on the S&P 500 as reason for this advice.

The implication is this: in the modern world, with abundantly available knowledge and data, these patterns simply do not work anymore.

She then quotes Michael Harris, who wrote a book called “Fooled By Technical Analysis”, as calling for some of these chart patterns to be “retired”.

After being on the wrong side of yet another failed Head & Shoulders pattern on EURGBP, it’s tempting to think that she might have a point.

Let’s Look At Some Research

Unfortunately Anora and Michael don’t give seem to give us much data to support their contention that head and shoulders patterns no longer “work”.

But I’ve been a bit more resourceful, and have managed to dig up a study on the topic.

This is a research paper undertaken by the New York Fed. It looked at trading Head and Shoulders patterns on a variety of currency pairs over a period of 21 years, from 1973 to 1994.

I’m the first to admit that the results aren’t exactly impressive.

Now, don’t get me wrong, the authors seem to suggest that there might be something there.

But if you’re looking for a licence to print unlimited quantities of cash, the Head and Shoulders pattern is definitely not that.

And also, the data used in the study ends in 1994. Remember, Anora and Michael have suggested that the knowledge and tech revolutions might have eroded the power of the Head and Shoulders pattern.

So it’s quite possible that the pattern is not working as well now as it did even in 1994.

So Anora and Michael are correct?

Should we retire the Head and Shoulders pattern then? And any other chart pattern that does not seem to exhibit a significant, on-going edge?

If they show no sustained statistical advantage, surely that is case closed?

They must be useless?

If Head and Shoulders patterns don’t “work”, then why on earth are we still looking at them?

Or Have We Missed The Point…

Well the answer to that question is also the point that both Anora and Michael, and many other market commentators, miss.

No technical pattern, if traded blindly over and over again, will display a statistical edge over the long term.

If such edge appeared, it would quickly be eroded – that’s how markets work.

Nothing that just so happened to work in the past can be relied upon to work in the future.

Markets evolve and change. Edges appear for a while and then they disappear. Everything is in a state of flux, there is no constant.

It’s the same in any line of business. What was profitable 20 years ago might not be profitable today. If something is working in your business now, there is no guarantee that it will work in the future.

The music industry is a good example. The profit opportunity, the “edge”, moved from vinyl to tape to CD to digital.

There was a time that selling CDs was profitable. Then, one day it was no longer profitable. The edge was eroded in favour of digital.

And now it seems like we are coming full circle, and that an edge seems to be appearing in vinyl again.

That’s the market changing. That’s how it works.

It’s our job as traders, and as business-people, to stay on top of the changing market.

Doing the same thing over and over might work for a while, but it won’t work forever.

You can’t trade Head and Shoulders patterns, or any chart patterns, blindly over and over again and expect to make money over the long term.

But that doesn’t mean that they aren’t incredibly useful.

If you use them properly, Head and Shoulders patterns can work fantastically well.

Here’s How You Use Head and Shoulders Patterns Properly

At their core, technical patterns work best when you use them to manage risk.

Technical patterns are frameworks which help us manage risk and project potential profits.

But that’s all they can do. They aren’t magic. They’re not secret or mythical.

They’re just tools that help us buy or sell at a good price.

They help us figure out when to get aggressive in the market, and when to get defensive.

Here are two examples to show you what I mean:

head_and_shoulders4-min

Back to the failed EURGBP example from earlier. In this set-up, I lost 62 pips. Not great, but not a calamity either.

Here is another example of a Head and Shoulders pattern from earlier in this year. The pair is USDJPY.

head and shoulders 3-min

This Head & Shoulders pattern did work out. I made a total of 2,024 pips over 7 trades during this set-up.

I used the Head & Shoulders pattern as a tool. It helped me judge when to limit my losses on EURGBP, and when to get really aggressive on USDJPY.

Traders, let me tell you something really important…

You can get into the market based on anything, it doesn’t matter.

Get into the market based on technicals, fundamentals, whatever you want.

Trade based on astrology or tea leaves, if that’s what floats your boat.

How you get into the market, and whether you buy or sell, is only a tiny part of the story.

What’s far more important, is risk management and money management. How you manage risk is far more important than whether a set-up or pattern “worked” or was “invalid”.

What’s most important is how much you make when you’re right and how much you lose when you’re wrong.

If you are looking for something that “works” I have a piece of advice for you.

Give up.

You’ll find no matter what you try, everything works sometimes and fails other times.

Everything works and everything doesn’t work.

For every Head and Shoulder pattern that failed I can show you a stock that fell on a good earnings release.

For every candlestick pattern that “failed”, I can show you an occasion where fundamental analysis “failed”.

The point is this: it’s not whether a trading strategy “works” or not. Regardless of whether that strategy is technical in nature, fundamental in nature, or reading tea leaves.

It’s about taking full advantage of the occasions that it does work, and limiting the damage when it doesn’t.

And as for Anora’s advice, I’m afraid I’m going to stick with these “invalid and “antiquated” chart patterns.

Yes, they don’t work every time. But as long as I continue using them properly, I’ll do just fine.

If that makes me a dummy, I’m able to live with that.

All the best!

Nigel

PS: If you want to learn more about how to squeeze every pip out of chart patterns that work while keeping losses to a minimum on the ones that fail, consider taking my Price Action Swing Trading Video Course. The Video Course comes as part of the Forex Useful Pro Membership.

DISCLAIMER & COPYRIGHT

This update is based on my analysis on my charting package. It may differ to yours as it can be affected by time, market movements, charting packages and broker prices. I accept no liability for loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on any information in this report or analysis.