Why Head & Shoulders Patterns?

Head & Shoulders | A Long History - From Ticker Tape to Electronic Order Flow

Traders have been taking advantage of the 'Head & Shoulders pattern since the early 1900s.

Understanding this repeating pattern provides you with tools to get, and maintain, your bearings.

A Head & Shoulders Pattern can also be represented as the using Elliott Wave.

  • Left Shoulder = 3
  • Head = 5
  • Right Shoulder = 3 (In the opposite direction of the Left Shoulder

Books that reference Head & Shoulders Pattern

  • Studies in Tape Reading | Rollo Tape | Published in 1910
  • The Wave Principle | Elliott | Published in 1938
  • Elliott Wave Principle | Prechter |Published 1978
  • Technical Analysis Explained | Pring | Published 1979
  • Charting Made Easy | Murphy | Published 2000

Head & Shoulders has become a mainstay of Technical Analysis.

A trader who solely monitors just the price action of a Head & Shoulders pattern does not leverage all of the order flow insights that are available to them.

 Stages of Head & Shoulders Pattern & The Right Shoulders Relevant Order Flow Events

We have identified the underlying order flow events that occur at each stage of a Head & Shoulder's pattern.  In this article we will focus on the order flow events of the Right Shoulder. 

  • The Left Shoulder, as the penultimate low sets up the conclusion of the move at the Head.  
  • The Head, as the Conclusion of the current move, establishes a reversal pattern which plays out by experiencing conclusionary selling.  The conclusionary selling sets up a state of exhaustion, which creates a temporary vacuum in the order book.  When the Head becomes a reversal it is because the vacuum in the order book was filled by new fuel in the opposite direction of the prior move.
  • The Right Shoulder is the lowest Pivot Low that occurs after the Head is established.  A Right Shoulder that is established can be superseded by a new pivot low as long as this pivot low is higher than the Head and lower than the current Right Shoulder.  The Right Shoulder takes advantage of the overall entire process that played out from the Left Shoulder, where an existing move played out the bulk of its lifespan, through the Head where the move cessated, to the Right Shoulder where a new acceleration point can be born.

...sceeto insight | The more that the Head & Shoulders pattern tracks to the order flow model, the more certainty in the ongoing progression of the move.

The following are the order flow events that support a Right Shoulder:

  • Order Flow Monitor Events
  • Tape Meter Events
  • MacDaddy - Rate of Change of Order Flow
  • Support of the arbitrage bots working both equity and futures order flow via WIND

  • Predominantly demand initiated order flow (Predominantly green MacDaddy bars)
  • Predominantly supply initiated order flow (Predominantly red MacDaddy bars)
  • Spike in MacDaddy
  • Price Action Bonus | Engulfing Bar at Right Shoulder

 A comparison of Idealized Head & Shoulders Using Better Data Insights to A Real-World Example

Idealized Head Shoulders via Better Data

Figure 1 | How order flow behaves at each stage of a Head & Shoulders pattern.

Head and Shoulders ES 31 AUG 2015 Long ES

Figure 2 | What Better Data Looks Like In The Real-Word.

Right Shoulder Core Order Flow & Price Action Concepts

Key Concept | Tradeable price moves are sustained by the support of order flow.  Without the support of order flow, a price move cannot be sustained.

Substantive market moves are usually supported by a predominance of either overall demand based order flow or supply based order flow.

A steady flow of either demand based order flow or supply based order flow is the hidden force that people are referring to when they say, ‘Don’t fight the tape’.

This hidden force can be readily visualized using MacDaddy.

Any series of MacDaddy bars that are primarily made of either green (demand) or red (supply) constitute this flowing force.

It is our job to stay on the right side of this force.

If it is a Long Right Shoulder then there should be an overall trend of buying in order flow.  This can be visualized as primarily ongoing green bars in MacDaddy.

If it is a Short Right Shoulder then there should be an overall trend of selling in order flow.

This can be visualized as primarily ongoing red bars in MacDaddy.

What Predominantly Demand Initiated Order Flow Looks Like:

MacDaddy Lift Long 01 Figure 3 | Ongoing Green MacDaddy Infers Supportive Buying Order Flow

What Predominantly Supply Initiated Order Flow Looks Like:

MacDaddy Lift Short 01

Figure 4 | Ongoing Red MacDaddy Infers Supportive Selling Order Flow

Key Concept | Spikes in MacDaddy | Resumption of Order Flow in the Direction of a Trend

Counter-trend spikes in MacDaddy infer that a counter-trend move is over and resumption of the primary trend is starting.

What a Long Counter Trend Spike in MacDaddy Looks Like

MacDaddy Spike Long 01Figure 5 | Once Completed, Red Counter Trend Spikes in MacDaddy Infers That Temporary Selling Has Concluded and Order Flow is Now Again Dominated by Demand Based Order Flow.

WHAT A Short COUNTER TREND SPIKE IN MACDADDY LOOKS LIKE

MacDaddy Spike Short 01 ES Order Flow
Figure 6 | Once Completed, Green Counter Trend Spike in MacDaddy Infers That Temporary Buying Has Concluded and Order Flow is Now Again Dominated by Supply Based Order Flow.

The Entry Stage | ‘Right Shoulder’ | Liftoff - The Price Discovery search for liquidity

Trader’s Goal

Note | This section will describe an Inverted Head & Shoulders pattern, which is a long (bullish) trade.

The insights provided can be inverted to trade a standard Head & Shoulders pattern, which is a short (bearish) trade.

The Right Shoulder is considered an ideal place to enter into a position.

The trader’s goal is to leverage both the ideal trade location of the Right Shoulder and also the supporting concomitant order flow behavior to position themselves to be in the front of a new leg upward.

By entering in this trade location where there are supporting order flow indications, the trader is in a position where newly arriving order flow will be predominantly to the demand side if they are trading an Inverted Head & Shoulders, or the order flow will be predominantly to the supply side if they are trading a standard Head & Shoulders.

This new buying order flow, which is now following the conclusion of selling order flow that occurred at the Head, occurs in an environment where the Supply & Demand curve is vulnerable to illiquidity.

At this sweet spot, the Price Discovery process can go into hyper-drive as there is an extreme imbalance between Buyers and Sellers.

In a nutshell, this extreme imbalance is why we spend so much time focused on the Right Shoulder as a trade entry location. 

The Stars Align | A potential entry has been established

If a Head & Shoulders pattern plays out in a manner that tracks what has been documented as an idealized setup, then the time is ripe for you to decide whether you would like to enter into the trade.

Our philosophy is that the trade entry is merely a gambit.  The setup itself does not guarantee that you will post a winning trade.

Once you enter a trade, there is an expectation that additional corroborating price action and order flow evidence will materialize.  This additional order flow is the force that will carry your position upward.

  • Observe price and tape’s (order flow) adherence to the model:

  • During periods of high alignment amongst price and tape with the model, traders have an inference that price will continue to adhere to the model, and hence, there is an ‘opportunity’ as the expectation is that price’s continuum should also track to the model.

Order Flow Insight | We consider our trading extremely ‘opportunistic’.  Hence, if price and order flow do not track to the model, then get out of the trade by either:

  1. Lowering profit target (Note – Profit targets can be lowered to a loss level).

  2. Raise your stop.

  3. Simply get flat by exiting the trade | i.e - Just leave…

Range Bars | Why we use ‘em

Trader’s Tip | Range Bars vs. Time Based Bars

Our method relies on Range Bars (or any bar using a chaotic price series) not on time base bars. 

Three rules of range bars:

  • Each range bar must have a high/low range that equals the specified range.
  • Each range bar must open outside the high/low range of the previous bar.
  • Each range bar must close at either its high or its low.

The primary reasons that we use Range Bars as opposed to time based bars are:

  1. By aligning order flow with Range Bars we can readily visualize where order flow had an impact on a change in Price.
  2. You can define a pivot at the close of range bar whereas with time based bars you cannot confirm a pivot until the bar after the pivot is formed closes.

Swing Strength | Strong, Stronger, Strongest - How to measure a swing’s strength

Note | Some traders use ‘Pivot’ for ‘Swing’ and vice versa.

These swing strength calculations use range bars.  Unlike time based bars, range bars can only close at either their low or their high.

When using range bars, if the low of a bar is lower than the prior bar and the bar closes at its high, then this bar forms a swing low.

If the high of a bar is higher than the prior bar and the bar closes at its low, then this bar forms a swing high.

How to determine a swing’s ‘left strength’.

Swing Low | Count out the bars to the left of a swing low until you reach a bar that contains a price that is lower than the low of the swing bar.  The left strength of the swing low is equal to the number of bars between these two bars.

Swing High | Count out the bars to the left of a swing high until you reach a bar that contains a price that is higher than the high of the swing bar.  The left strength of the swing high is equal to the number of bars between these two bars.

A Right Shoulder can have a left strength of 1 and still be tradeable.  However, the higher the left strength of the Right Shoulder, there is less likelihood that the Right Shoulder was created by market noise.

If you use a 4 tick range bar on the ES contract a Right Shoulder whose left strength is >= 5 is a strong candidate for trading.

Trading Right Shoulder Whose Left Strength is 1 or 2

You can trade a Right Shoulder that has a left strength of 1 or 2 if it is part of a larger trend trade.

When trading Right Shoulder’s that have a left strength of 1 or 2 that is not part of a larger trend trade, it is advisable that the Head is at a known level and that both the Head and the Right Shoulder have significant amounts of corroborating order flow to warrant the trade.

Best Practice | Immediately after a Head is established you should begin to start monitoring for potential Right Shoulders.   Once the first range bar after the Head that closes down, the next bar is a potential Right Shoulder.  As this is occurring you should be counting the left strength so that if a Right Shoulder that meets your minimum strength requirement occurs, you are ready to take the trade if the concomitant order flow substantiates the potential move.

The Entry

Enter on the open of the range bar that immediately proceeds the range bar that formed the Right Shoulder.

Entry Order Type Options

Traders have the option to use either market, limit, or stops to enter a trade.

Each has its advantages and disadvantages.

Limit Orders

Limit Order Defined

“A limit order is an order to buy or sell an instrument at a specific price or better.  A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher.  A limit order is not guaranteed to execute.  A limit order can only be filled if the instrument's market price reaches the limit price.  While limit orders do not guarantee execution, they help ensure that an investor does not pay more than a pre-determined price for an instrument.”

One of the nice benefits of using range bars is that you know that as it completes itself, it is rare that the open of the proceeding range bar is more than one tick away from the close of the current bar.

Depending upon the market, and your tolerance for risk, a limit order can be your best friend.

With limit orders you have the option to place your limit entry exactly at the open price of the range bar that proceeds the Right Shoulder bar, or you can elect to drop the limit entry by one tick so that it is equal to the close of the Right Shoulder bar.

You can decrement this limit entry by one more tick so that it your limit entry price is one tick below the close of the Right Shoulder bar.

The risk with each subsequent decrement in your entry price is that you are less and less likely to get filled.

If all of the stars have aligned, then the expectation is that price should accelerate to the upside while additional buying appears in the order flow.

If this is the case where all the stars have aligned, it is not likely that you are going to get filled anywhere but at the open of the bar that immediately proceeds the Right Shoulder range bar.

As a rule of thumb, if a setup is pristine and the market is behaving nicely, consider paying the premium to ensure that you get filled.

Stop Entry Orders

Stop orders have a benefit that they are easily staged.  If you are seeking to enter into a long position, and the current range bar is a candidate for a Right Shoulder (If the current range bar closes up a pivot low will be established) then you can place a Buy Stop Limit order in your trading DOM 5 ticks (depending on the level of your need to get into the trade) above the low of the candidate Right Shoulder bar.

For instance, if the current bar is a candidate for a Right Shoulder and the low of the current bar = 1,000, then you can place a Buy Stop Limit order at 1001.25 which is 5 ticks away from the low of the Right Shoulder candidate bar.

If you place the Buy Stop Limit order at 1,001.00 you are not allowing the 4 tick range bar to close, and hence, are jumping the gun.

The downside to this approach is that your standing limit order will be hit once price trades at 1,001.25 regardless of what order flow action transpired on the Right Shoulder bar.

For example, if you want either a 2 standard deviation tick ratio, or an increase in MacDaddy, or an Engulfing bar to occur at the Right Shoulder, your standing Buy Stop Limit order will not be cognizant of this information.

The caveat here is that with some custom programming, these types of order flow events can be introduced into a Buy Stop Limit order.

Market Orders

Market orders can be a blessing.  There easy and you know that you will get filled.  If you are trading a thick market such as ES, it is rare that you will fill at a higher price at the inside offer\ask for long entries, and at the inside bid for short entries.

Keep in mind that you always have the option to enter a limit order at the inside bid or inside ask.

A few words of Caution

If you get into a position and you realize that your entry is fighting the tape, get out.

If you get into a position and the tape turns against you, tighten your stops, or get out.

If a setup occurs and you miss the entry to the trade, and then buying immediately comes in and the market moves up, then, "whatever".  There will be another, even better, trade along shortly.

After you enter a long position, buying should come in right behind you

If you have entered in the ideal spot, then additional buying should come in immediately behind you. 

If the buying does not come in and move price up, then you have evidence that your entry was not at the ideal spot.

This is a crucial distinction.  When this happens you can either tighten your stop, or simply get out.

Once your position is flat, you can re-apprise the market situation and ready yourself for the next setup.

Stop Loss Orders

Stop loss orders, more familiarly known as ‘Stops’ are really the only things that matter when trading. 

Once could argue that there is more money to be made by smart stop loss management than by being brilliant at entries.

Each trader must create their own overall stop loss strategy, and incidentally stick with the Stop Loss strategy through good times and bad.

Your stop loss strategy should take into account your risk tolerance, account size, available time to trade, experience, and ‘pristineness’ of the current setup.

It is a good practice to attach your stop to your entry order so that your trading software automatically places your stop when your entry order is filled.

Stop Loss Strategy Approaches

  • Set # of Ticks | Standardize on a set number of ticks away from your entry price.  Anywhere from 4 – 10 ticks in the ES is reasonable for day traders.

  • 1 tick below the most recent pivot | If you are trading a 4 tick range bar and your entry practice is to limit your entry price to the open of the range bar that proceeded the Right Shoulder bar, then you would place your stop loss 6 ticks below your entry price.

    • 4 Tick Right Shoulder Bar | Low = 1,000;  Close = 1001
    • Entry Bar | Open = 1,001.25
    • Stop | 1 Tick Below The Low of Right Shoulder Bar = 999.75

e.g. | 6 Ticks = Entry Bar Open 1,001.25 - 1 Tick below the Low of Right Shoulder Bar = 999.75

Tightening Your Stops

There are a few different approaches to tightening your stops. 

Each trader must create a stop tightening strategy that is in harmony with risk tolerance, account size, available time to trade, experience, and ‘pristineness’ of the current setup.

  • Move stop to breakeven once price has moved 8 profitable ticks.

  • Move stop to breakeven + 1 tick price has moved 8 profitable ticks.

  • Trail stop by 8 ticks from the high of the trade.

  • Trail stop by 1 tick below the most recent pivot low for long trades (1 tick above the most recent pivot high for short trades).  This approach carries with it the risk of being stopped out by an Elliott Wave ABC corrective wave that retraces into the trend.

Profit Targets

A trader must create their own profit target strategy based that is in harmony with their tolerance for risk, account size, available time to trade, experience, and ‘pristineness’ of the current setup.

Static Target

Set target 8-12 ticks away from entry price.

Dynamic Target

Set target at the next known resistance level.

If price accelerates to the next resistance level and order flow remains supportive then move target up to the next resistance level and adjust the stop according to your risk tolerance (at least to breakeven).

...sceeto

The supporting order flow data that is presented on this page was generated by ...sceeto.

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