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Price Smoothies
A moving average is simply a way to smooth out price action over time. By “moving average”, we mean that you are taking the average closing price of a currency for the last ‘X’ number of periods.
Like every indicator, a moving average indicator is used to help us forecast future prices. By looking at the slope of the moving average, you can make general predictions as to where the price will go.
As we said, moving averages smooth out price action. There are different types of moving averages, and each of them has their own level of “smoothness”. Generally, the smoother the moving average, the slower it is to react to the price movement. The choppier the moving average, the quicker it is to react to the price movement.
We’ll explain the pros and cons of each type a little later, but for now let’s look at the different types of moving averages and how they are calculated.
We’ll explain the pros and cons of each type a little later, but for now let’s look at the different types of moving averages and how they are calculated.
Exponential Moving Average
Exponential Moving Average (EMA)
Although the simple moving average is a great tool, there is one major flaw associated with it. Simple moving averages are very susceptible to spikes. Let me show you an example of what I mean:
Let’s say we plot a 5 period SMA on the daily chart of the EUR/USD and the closing prices for the last 5 days are as follows:
Day 1: 1.2345
Day 2: 1.2350
Day 3: 1.2360
Day 4: 1.2365
Day 5: 1.2370
The simple moving average would be calculated as
(1.2345+1.2350+1.2360+1.2365+1.2370)/5= 1.2358
Simple enough right?
Well what if Day 2’s price was 1.2300? The result of the simple moving average would be a lot lower and it would give you the notion that the price was actually going down, when in reality, Day 2 could have just been a one time event (maybe interest rates decreasing).
The point I’m trying to make is that sometimes the simple moving average might be too simple. If only there was a way that you could filter out these spikes so that you wouldn’t get the wrong idea. Hmmmm…I wonder….Wait a minute……Yep, there is a way!
It’s called the Exponential Moving Average!
Exponential moving averages (EMA) give more weight to the most recent periods. In our example above, the EMA would put more weight on Days 3-5, which means that the spike on Day 2 would be of lesser value and wouldn’t affect the moving average as much. What this does is it puts more emphasis on what traders are doing NOW.
When trading, it is far more important to see what traders are doing now rather than what they did last week or last month
SMA vs. EMA
Which is better: Simple or Exponential?
First, let’s start with an exponential moving average. When you want a moving average that will respond to the price action rather quickly, then a short period EMA is the best way to go. These can help you catch trends very early, which will result in higher profit. In fact, the earlier you catch a trend, the longer you can ride it and rake in those profits!
The downside to the choppy moving average is that you might get faked out. Because the moving average responds so quickly to the price, you might think a trend is forming when in actuality; it could just be a price spike.
With a simple moving average, the opposite is true. When you want a moving average that is smoother and slower to respond to price action, then a longer period SMA is the best way to go.
Although it is slow to respond to the price action, it will save you from many fake outs. The downside is that it might delay you too long, and you might miss out on a good trade.
SMA | EMA | |
Pros: | Displays a smooth chart, which eliminates most fakeouts. | Quick moving, and is good at showing recent price swings. |
Cons: | Slow moving, which may cause a lag in buying and selling signals. | More prone to cause fakeouts and give errant signals. |
So which one is better? It’s really up to you to decide. Many traders plot several different moving averages to give them both sides of the story. They might use a longer period simple moving average to find out what the overall trend is, and then use a shorter period exponential moving average to find a good time to enter a trade.
In fact, many trading systems are built around what is called “Moving Average Crossovers”. Later in this course, we will give you an example of how you can use moving averages as part of your trading system.
Time for recess! Go find a chart and start playing with some moving averages. Try out different types and look at different periods. In time, you will find out which moving averages work best for you. Class dismissed!
BOLLINGER BAND
and more tools to your trader’s toolbox. “What’s a trader’s toolbox?” you say… Simple! Your trader’s toolbox is what you will use to “build” your trading account. The more tools (education) you have in your trader’s toolbox (YOUR BRAIN), the easier it will be for you to build.
So for this lesson, as you learn each of these indicators, think of them as a new tool that you can add to that toolbox of yours. You might not necessarily use all of these tools, but it’s always nice to have the option, right? Now, enough about tools already! Let’s get started!
BollingerCongratulations on making it to the 5th grade! Each time you make it to the next grade you continue to add more Bands
Bollinger bands are used to measure a market’s volatility. Basically, this little tool tells us whether the market is quiet or whether the market is LOUD! When the market is quiet, the bands contract; and when the market is LOUD, the bands expand. Notice on the chart below that when the price was quiet, the bands were close together, but when the price moved up, the bands spread apart.
That’s all there is to it. Yes, we could go on and bore you by going into the history of the Bollinger band, how it is calculated, the mathematical formulas behind it, and so on and so forth, but we really didn’t feel like typing it all out.
In all honesty, you don’t need to know any of that junk. We think it’s more important that we show you some ways you can apply the Bollinger bands to your trading.
Note: If you really want to learn about the calculations of a Bollinger band, then you can go to www.bollingerbands.com
The Bollinger Bounce
One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the Bollinger bounce (smart, huh?). If this is the case, then by looking at the chart below, can you tell us where the price might go next?
If you said down, then you are correct! As you can see, the price settled back down towards the middle area of the bands.
That’s all there is to it. What you just saw was a classic Bollinger bounce. The reason these bounces occur is because Bollinger Bands act like mini support and resistance levels. The longer the time frame you are in, the stronger these bands are. Many traders have developed systems that thrive on these bounces, and this strategy is best used when the market is ranging and there is no clear trend.
Now let’s look at a way to use Bollinger Bands when the market does trend.
Bollinger Squeeze
The Bollinger squeeze is pretty self explanatory. When the bands “squeeze” together, it usually means that a breakout is going to occur. If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break out below the lower band, then the move will usually continue to go down.
Looking at the chart above, you can see the bands squeezing together. The price has just started to break out of the top band. Based on this information, where do you think the price will go?
If you said up, you are correct! This is how a typical Bollinger Squeeze works. This strategy is designed for you to catch a move as early as possible. Setups like these don’t occur everyday, but you can probably spot them a few times a week if you are looking at a 15 minute chart.
So now you know what Bollinger Bands are, and you know how to use them. There are many other things you can do with Bollinger Bands, but these are the 2 most common strategies associated with them. So now you can put this in your trader’s toolbox, and we can move on to the next indicator.
MACD
MACD is an acronym for Moving Average Convergence Divergence. This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish. After all, our #1 priority in trading is being able to find a trend, because that is where the most money is made.
With an MACD chart, you will usually see three numbers that are used for its settings.
- The first is the number of periods that is used to calculate the faster moving average.
- The second is the number of periods that are used in the slower moving average.
- And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.
For example, if you were to see “12,26,9” as the MACD parameters (which is usually the default setting for most charting packages), this is how you would interpret it:
- The 12 represents the previous 12 bars of the faster moving average.
- The 26 represents the previous 26 bars of the slower moving average.
- The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (The blue lines in the chart above).
There is a common misconception when it comes to the lines of the MACD. The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.
In our example above, the faster moving average is the moving average of the difference between the 12 and 26 period moving averages. The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9 period moving average.
This means that we are taking the average of the last 9 periods of the faster MACD line, and plotting it as our “slower” moving average. What this does is it smoothes out the original line even more, which gives us a more accurate line.
The histogram simply plots the difference between the fast and slow moving average. If you look at our original chart, you can see that as the two moving averages separate, the histogram gets bigger. This is called divergence, because the faster moving average is “diverging” or moving away from the slower moving average.
As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average. And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, we need to crack our knuckles after that one!
Ok, so now you know what MACD does. Now I’ll show you what MACD can do for YOU.
MACD Crossover
Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one. When a new trend occurs, the fast line will react first and eventually cross the slower line. When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed.
From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend. Notice that when the lines crossed, the histogram temporarily disappears. This is because the difference between the lines at the time of the cross is 0. As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is good indication of a strong trend.
There is one drawback to MACD. Naturally, moving averages tend to lag behind price. After all, it's just an average of historical prices. Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag. However, it is still one of the most favored tools by many traders.
Parabolic SAR
Up until now, we’ve looked at indicators that mainly focus on catching the beginning of new trends. And although it is important to be able to identify new trends, it is equally important to be able to identify where a trend ends. After all, what good is a well-timed entry without a well-timed exit?
One indicator that can help us determine where a trend might be ending is the Parabolic SAR (Stop And Reversal). A Parabolic SAR places dots, or points, on a chart that indicate potential reversals in price movement. From the chart below, you can see that the dots shift from being below the candles during the uptrend, to above the candles when the trend reverses into a downtrend.
One indicator that can help us determine where a trend might be ending is the Parabolic SAR (Stop And Reversal). A Parabolic SAR places dots, or points, on a chart that indicate potential reversals in price movement. From the chart above, you can see that the dots shift from being below the candles during the uptrend, to above the candles when the trend reverses into a downtrend.
Using Parabolic SAR
The nice thing about the Parabolic SAR is that it is really simple to use. Basically, when the dots are below the candles, it is a buy signal; and when the dots are above the candles, it is a sell signal. This is probably the easiest indicator to interpret because it assumes that the price is either going up or down. With that said, this tool is best used in markets that are trending, and that have long rallies and downturns. You DON’T want to use this tool in a choppy market where the price movement is sideways.
Stochastics
Stochastics
Stochastics are another indicator that helps us determine where a trend might be ending. By definition, a stochastic is an oscillator that measures overbought and oversold conditions in the market. The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.
How to Apply Stochastics
Like I said earlier, stochastics tells us when the market is overbought or oversold. Stochastics are scaled from 0 to 100. When the stochastic lines are above 70 (the red dotted line in the chart above), then it means the market is overbought. When the stochastic lines are below 30 (the blue dotted line), then it means that the market is oversold. As a rule of thumb, we buy when the market is oversold, and we sell when the market is overbought.
Looking at the chart above, you can see that the stochastics has been showing overbought conditions for quite some time. Based upon this information, can you guess where the price might go?
If you said the price would drop, then you are absolutely correct! Because the market was overbought for such a long period of time, a reversal was bound to happen.
That is the basics of stochastics. Many traders use stochastics in different ways, but the main purpose of the indicator is to show us where the market is overbought and oversold. Over time, you will learn to use stochastics to fit your own personal trading style. Okay, let's move on to RSI.
Relative Strength Index
Relative Strength Index, or RSI, is similar to stochastics in that it identifies overbought and oversold conditions in the market. It is also scaled from 0 to 100. Typically, readings below 20 indicate oversold, while readings over 80 indicate overbought.
Using RSI
RSI can be used just like stochastics. From the chart above you can see that when RSI dropped below 20, it correctly identified an oversold market. After the drop, the price quickly shot back up.
RSI is a very popular tool because it can also be used to confirm trend formations. If you think a trend is forming, take a quick look at the RSI and look at whether it is above or below 50. If you are looking at a possible uptrend, then make sure the RSI is above 50. If you are looking at a possible downtrend, then make sure the RSI is below 50.
In the beginning of the chart above, we can see that a possible uptrend was forming. To avoid fakeouts, we can wait for RSI to cross above 50 to confirm our trend. Sure enough, as RSI passes above 50, it is a good confirmation that an uptrend has actually formed. Okey dokey, we've covered a smorgasbord of indicators, let's see how we can put all of what you just learned together...
Putting It All Together
In a perfect world, we could take just one of these indicators and trade strictly by what that indicator told us. The problem is that we DON’T live in a perfect world, and each of these indicators has imperfections. That is why many traders combine different indicators together so that they can “screen” each other. They might have 3 different indicators and they won’t trade unless all 3 indicators give them the same answer.
As you continue you journey as a trader, you will discover what indicators work best for you. We can tell you that we like using MACD, Stochastics, and RSI, but you might have a different preference. Every trader out there has tried to find the “magic combination” of indicators that will always give them the right signals, but the truth is that there is no such thing.
We urge you to study each indicator on its own until you know EXACTLY how it reacts to price movement, and then come up with your own combination that fits your trading style. Later on in the course, we will show you a system that combines different indicators to give you an idea of how they can compliment each other.
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OSCILLATOR AND MOMENTUM INDICATORS
Leading vs. Lagging Indicators
We’ve covered a lot of tools that can help you analyze charts and identify trends. In fact, you may now have too much information to use effectively.
In this lesson, we’re going to look at streamlining your use of these chart indicators. We want you to fully understand the strengths and weaknesses of each tool, so you’ll be able to determine which ones work for you and your trading plan…and which ones don’t.
Leading versus Lagging Indicators
Let’s discuss some concepts first. There are two types of indicators: leading and lagging.
A leading indicator gives a buy signal before the new trend or reversal occurs.
A lagging indicator gives a signal after the trend has started and basically informs you “hey buddy, pay attention, the trend has started, you’re missing the boat.”
You’re probably thinking, “Ooooh, I’m going to get rich with leading indicators!” since you would be able to profit from a new trend right at the start. You’re right – you would “catch” the entire trend every single time, IF the leading indicator was correct every single time. But it’s not.
When you use leading indicators, you will experience a lot of fake-outs. Leading indicators are notorious for giving bogus signals which will “mislead” you. Get it? Leading indicators that "mislead" you? Ha-ha. Man we're so funny we even crack ourselves up.
The other option is to use lagging indicators, which aren’t as prone to bogus signals. Lagging indicators only give signals after the price change is clearly forming a trend. The downside is that you’d be a little late in entering a position. Often the biggest gains of a trend occur in the first few bars, so by using a lagging indicator you could potentially miss out on much of the profit. Which sucks.
Oscillators and Trend Following Indicators
For the purpose of this lesson, let’s broadly categorize all of our technical indicators into one of two categories:
- Oscillators
- Trend following or momentum indicators
Oscillators are leading indicators.
Momentum indicators are lagging indicators.
While the two can be supportive of each other, they're more likely to conflict with each other. We’re not saying that one or the other should be used exclusively, but you must understand the potential pitfalls of each.
Oscillators / Leading Indicators
An oscillator is any object or data that moves back and forth between two points. In other words, it’s an item that is going to always fall somewhere between point A and point B. Think of when you hit the oscillating switch on your electric fan.
Think of our technical indicators as either being “on” or “off”. More specifically, an oscillator will usually signal “buy” or “sell”, with the only exception being instances when the oscillator is not clearly at either end of the buy/sell range.
Does this sound familiar? It should! Stochastics, Parabolic SAR, and the Relative Strength Index (RSI) are all oscillators. Each of these indicators is designed to signal a possible reversal, where the previous trend has run its course and the price is ready to change direction.
Let’s take a look at a few examples.
On the 1-hour chart of USD/EUR below, we have added a Parabolic SAR indicator, as well as an RSI and Stochastic oscillator. As you have already learned, when the Stochastic and RSI begin to leave their “oversold” region that is a buy signal.
Here we get buy signals between the hours 3:00 am EST and 7:00 am EST on 08/24/05. All three of these buy signals occurred within one or two hours of each other, and this would have been a good trade.
We also got a sell signal from all three indicators between the hours of 2:00 am EST and 5:00 am EST on 08/25/05. As you can see, the Stochastic indicator remained in the overbought for a pretty long time - about 20 hours. Usually when an oscillator remains in the overbought or oversold levels for a long period of time, that means there is a strong trend occurring. In this example, since Stochastic stayed overbought, you see there was a strong uptrend present.
Now let’s take a look at the same leading oscillators messing up, just so you know these signals aren’t perfect. Looking at the chart below, you can quickly see that there were a lot of false buy signals popping up. You’ll see how one indicator says to buy, while the other one is still saying sell.
Around 1 am EST on 08/16/05, both RSI and Stochastic gave buy signals, while Parabolic SAR still showed a sell signal. Yes, Parabolic SAR gave a buy signal 3 hours later at 4 am EST, but then Parabolic SAR turned into a sell signal one bar later. If you actually look at the bar with the Parabolic SAR below it, notice how it’s a strong looking red bar with very short shadows. Also, notice how the next bar closed below it. This would not have been a good long trade.
On the last two oversold (buy) signals given by Stochastic, notice how there is no indicator at all for RSI, but Parabolic SAR is giving sell signals. What’s going on here? They are each giving you different signals!
What happened to such a good set of indicators?
The answer lies in the method of calculation for each one. Stochastic is based on the high-to-low range of the time period (in this case, it’s hourly), yet doesn’t account for changes from one hour to the next. The Relative Strength Index (RSI) uses change from one closing price to the next. And Parabolic SAR has its own unique calculations that can further cause conflict.
That’s the nature of oscillators – they assume that a particular chart pattern always results in the same reversal. Of course, that’s hogwash.
While being aware of why a leading indicator may be in error, there’s no way to avoid them. If you’re getting mixed signals, you’re better off doing nothing than taking a ‘best guess’. If a chart doesn’t meet all your criteria, don’t force the trade! Move on to the next one that does meet your criteria.
Momentum / Lagging Indicators
So how do we spot a trend? The indicators that can do so have already been identified as MACD and moving averages. These indicators will spot trends once they have been established, at the expense of delayed entry. The bright side is that there’s less chance of being wrong.
On this 1-hour chart of EUR/USD, there was a bullish crossover for MACD at 3:00 am EST on 08/03/05 and the 10 period EMA crossed over the 20 period EMA at 5:00 am. These two signals were all accurate, but if you waited for both indicators to give you a bull signal, you would have missed out of the big move. If you calculate from the start of the uptrend at 10:00 pm EST on 08/02/05 to the close of the candle at 5:00 am EST on 08/03/05, you would have watched a gain of 159 pips while sitting on the sidelines.
Let’s take a look at the same chart so you can see how these crossover signals can sometimes give false signals. We like to call them “fake-outs”. Look at how there was a bearish MACD crossover after the uptrend we just discussed.
Ten hours later, the 20 EMA crossed below the 10 EMA giving a “sell” signal. As you can see, the price didn’t drop but stayed pretty much sideways, then continued its uptrend. By the time both indicators were in agreement, you would’ve entered a short trade at the bottom and set yourself up for a loss. Bummer, dude!
IMPORTANT CHART PATTERN
Pattern Schmatterns
By now you have an arsenal of weapons to use when you battle the market. In this lesson you will add yet another weapon: CHART PATTERNS!
Think of chart patterns as a land mine detector, because once you learn this, you will be able to spot “explosions” on the charts before they even happen, making you a lot of money in the process.
In this lesson, we will teach you basic chart patterns and formations. When correctly identified, it usually leads to a huge breakout or “explosion” in this case.
Remember, our whole goal is to spot big movements before they happen so that we can ride them out and rake in the cash!Chart formations will greatly help us spot conditions where the market is ready to break out.
Here's the list of patterns that we're going to cover:
- Symmetrical Triangles
- Ascending Triangles
- Descending Triangles
- Double Top
- Double Bottom
- Head and Shoulders
- Reverse Head and Shoulders
Symmetrical Triangles
Symmetrical triangles are chart formations where the slope of the price’s highs and the slope of the price’s lows converge together to a point where it looks like a triangle. What is happening during this formation is that the market is making lower highs and higher lows. This means that neither the buyers nor the sellers are pushing the price far enough to make a clear trend. If this was a battle between the buyers and sellers, then this would be a draw.
This type of activity is called consolidation.
In the chart above, we can see that neither the buyers nor the sellers could push the price in their direction. When this happens we get lower highs and higher lows. As these two slopes get closer to each other, it means that a breakout is getting near. We don’t know what direction the breakout will be, but we do know that the market will break out. Eventually, one side of the market will give in.
So how can we take advantage of this? Simple. We can place entry orders above the slope of the lower highs and below the slope of the higher lows. Since we already know that the price is going to break out, we can just hitch a ride in whatever direction the market moves.
In this example, if we placed an entry order above the slope of the lower highs, we would’ve been taken along for a nice ride up. If you had placed another entry order below the slope of the higher lows, then you would cancel it as soon as the first order was hit.
Ascending Triangles
This type of formation occurs when there is a resistance level and a slope of higher lows. What happens during this time is that there is a certain level that the buyers cannot seem to exceed. However, they are gradually starting to push the price up as evident by the higher lows.
In the chart above, you can see that the buyers are starting to gain strength because they are making higher lows. They keep putting pressure on that resistance level and as a result, a breakout is bound to happen. Now the question is, “Which direction will it go? - Will the buyers be able to break that level or will the resistance be too strong?”
Many charting books will tell you that in most cases, the buyers will win this battle and the price will break out past the resistance. However, it has been my experience that this is not always the case. Sometimes the resistance level is too strong, and there is simply not enough buying power to push it through.
Most of the time the price will in fact go up. The point we are trying to make is that we do not care which direction the price goes, but we want to be ready for a movement in EITHER direction. In this case, we would set an entry order above the resistance line and below the slope of the higher lows.
In this scenario, the buyers won the battle and the price proceeded to skyrocket!
Descending Triangles
As you probably guessed, descending triangles are the exact opposite of ascending triangles (we knew you were smart!). In descending triangles, there is a string of lower highs which forms the upper line. The lower line is a support level in which the price cannot seem to break.
In the chart above, you can see that the price is gradually making lower highs which tell us that the sellers are starting to gain some ground against the buyers. Now most of the time, and we did say MOST - the price will eventually break the support line and continue to fall.
However, in some cases the support line is too strong, and the price will bounce off of it and make a strong move up.
The good news is that we don’t care where the price goes. We just know that it’s about to go somewhere. In this case we would place entry orders above the upper line (the lower highs) and below the support line.
In this case, the price did end up breaking the support line and proceeded to drop rather quickly. (*note- The market tends to fall faster than it rises which means you usually make money faster when you are short).
Double Top
A double top is a reversal pattern that is formed after there is an extended move up. The “tops” are peaks which are formed when the price hits a certain level that can’t be broken. After hitting this level, the price will bounce off it slightly, but then return back to test the level again. If the price bounces off of that level again, then you have a DOUBLE top!
In the chart above you can see that two peaks or “tops” were formed after a strong move up. Notice how the 2nd top was not able to break the high of the 1st top. This is a strong sign that a reversal is going to occur because it is telling us that the buying pressure is just about finished.
With double tops, we would place our entry order below the neckline because we are anticipating a reversal of the uptrend.
Wow! We must be psychic or something because we always seem to be right! Looking at the chart you can see that the price breaks the neckline and makes a nice move down. Remember, double tops are a trend reversal formation. You’ll want to look for these after there is a strong uptrend.
Double Bottom
Double bottoms are also trend reversal formations, but this time we are looking to go long instead of short. These formations occur after extended downtrends when two valleys or “bottoms” have been formed.
You can see from the chart above that after the previous downtrend, the price formed two valleys because it wasn’t able to go below a certain level. Notice how the 2nd bottom wasn’t able to significantly break the 1st bottom.
This is a sign that the selling pressure is about finished, and that a reversal is about to occur. In this situation, we would place an entry order above the neckline.
Would you look at that!
The price breaks the neckline and makes a nice move up. Remember, just like double tops, double bottoms are also trend reversal formations. You’ll want to look for these after a strong downtrend.
Head and Shoulders
A head and shoulders pattern is also a trend reversal formation. It is formed by a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder). A “neckline” is drawn by connecting the lowest points of the two troughs. The slope of this line can either be up or down. In my experience, when the slope is down, it produces a more reliable signal.
In this example, we can visibly see the head and shoulders pattern. The head is the 2nd peak and is the highest point in the pattern. The two shoulders also form peaks but do not exceed the height of the head.
With this formation, we look to make an entry order below the neckline. We can also calculate a target by measuring the high point of the head to the neckline. This distance is approximately how far the price will move after it breaks the neckline.
You can see that once the price goes below the neckline it makes a move that is about the size of the distance between the head and the neckline.
Reverse Head and Shoulders
The name speaks for itself. It is basically a head and shoulders formation, except this time it’s in reverse. A valley is formed (shoulder), followed by an even lower valley (head), and then another higher valley (shoulder). These formations occur after extended downward movements.
Here you can see that this is just like a head and shoulders pattern, but it’s flipped upside down. With this formation, we would place a long entry order above the neckline. Our target is calculated just like the head and shoulders pattern. Measure the distance between the head and the neckline, and that is approximately the distance that the price will move after it breaks the neckline.
You can see that the price moved up nicely after it broke the neckline. WE know you’re thinking to yourself, “the price kept moving even after it reached the target.”
And our response is, “DON”T BE GREEDY!”
If your target is hit, then be happy with your profits. However, there are strategies where you can lock in some of your profits and still keep your trade open in case the price continues to move your way. You will learn about those later on in the course.
