CORE CONCEPTS OF THE ‘IDEAL’ HEAD & SHOULDERS PATTERN

A Head & Shoulders Pattern is made up of 3 primary phases:

  1. The Left Shoulder
  2. The Head
  3. The Right Shoulder
  • Each phase has its own unique set of insights.
  • 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, which sets up a state of exhaustion, which creates a temporary vacuum in the order book, this vacuum is eventually filled by new fuel in the opposite direction of the prior move.
  • The Right Shoulder takes advantage of this new fuel.

STAGE 1 | ‘LEFT SHOULDER’ AKA ‘3 OF AN ELLIOT IMPLUSE WAVE’ (PENULTIMATE HIGH / LOW)

Price | Ebbing Price Momentum

  • Bollinger Band (Standard Deviation Price Moves)
    • Price pauses at and extends Bollinger Band
    • Price continues in current direction due to inertia

Order Flow | Diminishing Overall Demand

  • MacDaddy (Applied Force)
    • Lower High MacDaddy accompanied by Higher High in Price

STAGE 2 | ‘HEAD’ - OVERBOUGHT / OVERSOLD COUPLED WITH CONCLUSIONARY ORDER FLOW

The Ideal Head:

  • Occurs at a Known Level
  • Is accompanied by Exhaustion
  • Closes with new buying fuel

Key Point | The head of a Head & Shoulders pattern is a reversal pattern.

A LONG REVERSAL IS COMPRISED OF THREE LOGICAL PHASES

The 3 logical phases of a Long Reversal

This reversal sequence is not only logical, but also each component can be further defined in its own right with its own components. This allows us to more readily observe each phase and to prepare for the next phase, and then to be ready if a potential entry opportunity materializes.

For simplicity sake, we will start out focusing on a Long Reversal example. The logic flow for a Short Reversal is the same as a Long reversal except inverted.




PHASE 03 OF A REVERSAL | CONCLUSION OF SELLING

A Long Reversal begins with the conclusion of selling from the current downward move.

If you are a 21st Century Tape Reader there are multiple indications that you can use to help you observe whether conclusionary selling is transpiring.

Conclusionary selling can be visualized in many forms such as HFT Sell Surges or Bearish Tick Ratios. A complete list can be found.

Conclusionary selling does not occur at a point of breakout but rather at the point of price extension.

Trader’s Tip | The correct location for conclusionary selling is:

  • After a downward move has been in place
  • At a known price level

PHASE 03 OF A REVERSAL | A REVERSAL IN PRICE @ A KNOWN LEVEL

Defining a Price Reversal

Someone once said to me that ‘Price is the ultimate indicator.'  The simplicity of this statement stunned me.

“Price is the ultimate indicator.”  This concept still stops me in my tracks when I think about it.  For a reversal to occur, price actually has to change direction. We may be stating the obvious here, but this is a critical component – one which we can break down into observable components.

Since we enter buy and sell orders based on Price and not Bollinger Bands, it makes sense to incorporate changes in Price as a core component of our trading methodology.

But if Price is the ultimate indicator, why do so many traders get tripped up trying to deduce, in real-time, which dips, pullbacks, pivots, Zig-Zags, Fibonacci retracements etc. constitute a reversal, and which is merely a temporary pause in the current trend?

Price alone will emphatically tell you whether it just went up or down from the last tick, but it gets a little trickier as to whether the most recent uptick is going to be the last uptick in a long and lustrous line of upticks, or whether this last uptick was a pause in the action.  Is this last uptick is, as Jim Morrison so notably declared when he sang, “Oh, this is the end. My only friend, the end"?

The answer to this dilemma is to view and analyze Price, and Price Patterns, in the overall context of Market Levels as well as Order Flow.

For price to reverse at a known level we must have a handle on both what a price reversal looks like and what a known level is.

To do this, we leverage Range Bars. We define a Long Pivot to have occurred when a range bar closes at the high and the prior bar to have closed at the low.

This pivot, though potentially minuscule, is the basis for considering a Long Reversal.

The dilemma with knowing when a Long Reversal has occurred is that you will never know until the move plays out.

Depending upon your trading timeframe, it can take a long time to answer this question.

For our model, what we focus on is whether one minor Long Pivot has a greater potential to evolve into a viable long trade or not.

For this to be determined we need to define your most comfortable trading swing.

If we are going to use the ES then we can group a trader’s profit target propensity into the following groups:

Scalper | 1 – 4 ticks

Quickie Trader | 5-12 ticks

Intra-Day Swing Trader | > 12 ticks

Note | You may have different definitions of trade profit duration, but we will use these so that our discussion throughout this book stays consistent.

If Price reverses at an area that is not a known level, it may either be a tradeable reversal or a pause in the action. Regardless, we exclude these reversals from our analysis. We only focus on pivots at known levels with the goal of determining the likelihood that these pivots will evolve into tradeable reversals.

Though it may be intuitive and a commonly held belief, the earlier we make the determination that a new trend is underway, the sooner we will enjoy a longer trade - there is a counter-argument that is equally compelling.

The longer that we wait for confirmation that a reversal is in place, the higher the likelihood that a trade dependent upon this determination will be successful.

It is my hope that the following content will help you find your footing between these two competing approaches.


THE LOW VS. THE RIGHT SHOULDER

Earlier in this book we discussed what a In this section we will discuss where the Right Shoulder shines in importance with regards to the great debate between ‘Buying the Low’ and ‘Waiting for Confirmation of the Trend’.

I propose that neither one is correct and the other incorrect, nor is one better than the other, but rather that there are significant findings that can help you decide whether one location is better for your style of trading, or perhaps under which circumstances one of these locales is more suspect and should be traded with more caution.

The primary tool set for understanding whether a pivot at the low, or a pivot at the right shoulder will hold, is Order Flow.

If we see Conclusionary Selling coming in a known low, and then a low pivot is formed, we have the potential for a tradable long reversal.

If this is accompanied by one or more of the Price Action Indications and Patterns defined earlier in the book, then this is more corroborating evidence that a tradable turn is forming.

Is this formation enough to enter a trade or should we wait for more evidence? Here’s a framework for you to help make this decision. You can make this decision on a trade setup by trade setup basis, or you can understand these nuances and make a global decision that you will:

-only trade the low

-trade the right shoulder when appropriate

-trade either the low or the right shoulder

-trade the low and add to your position at the right shoulder if the Order Flow infers that a trend is in place.

Trader’s Tip | Using Order Flow To Add to a Profitable Position


PHASE 03 OF A REVERSAL | DOMINACE OF HFT BUYING

This third phase, Dominance of HFT Buying, is the icing on the cake. It is the ribbon on the present. It is, to use trader’s parlance, the confirmation signal.

If we experience conclusionary selling coming into a known level, and we see price reverse at a known level, and then we see those lovely little HFT bots buying away, well then, we have got us one rootin’, tootin’ reversal.

All the key components of a reversal are in place. We have looked under the hood of the market through a powerful electronic microscope and seen the light. It is all there for us to see and observe…it is a truly wondrous thing to behold.

Why is the HFT buying so important at the end of this very distinct sequence?

It all comes back to the laws of Supply & Demand. The ‘demand’ created by the buy orders generated by these trading bots will usurp the local supply of available stock or futures which will kick off a substantive Price Discovery process which is where price will move up the price ladder in the hunt for liquidity to satiate the buying orders and demand of the trading bots. This is the sweet spot. This is the behavioral event(s) that we, as traders are looking for. This is where we hang our trading hat.

Price | Excursion beyond Standard Deviation

  • End State - A Vacuum is created. The final surge in demand invoked by late buyers, margin squeezes, and triggered stop losses, coupled with the decrement in demand based order flow (Surfaced via MacDaddy) leaves a market state where there is no demand left, sometimes known as buying exhaustion.

Trader’s Insight | Conclusion of Buying at a known resistance level is a plus.


STAGE 3 | ‘RIGHT SHOULDER’ - LIFTOFF - THE PRICE DISCOVER SEARCH FOR LIQUIDITY

Right Shoulder Defined

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.

Trader’s Goal

The Right Shoulder can be 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 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 buy side.

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 Entry

Enter at the open of the bar following the bar that formed the Right Shoulder.

What to Look For in Order Flow

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





The secret sauce is a recipe composed of key ingredients in the Right Shoulder’s concomitant order flow.

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

  • Green/Long Order Flow Monitor Events
  • Green/Long Tape Meter Events
  • MacDaddy - Surfaced by
    • Predominantly demand initiated order flow (Predominantly green MacDaddy bars)
    •  
    • Red Spike in MacDaddy
  • Equities order flow via WIND
  • Bonus | Engulfing Bar at Right Shoulder

Right Shoulder Core Order Flow & Price Action Concepts?

Predominantly demand initiated order flow should lift & support price action.

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’. We expand on this, and say “Don't fight the Tape – Use Better Data”

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:

Figure x.x | Ongoing Green MacDaddy Infers Supportive Buying Order Flow

What Predominantly Supply Initiated Order Flow Looks Like: BDS SCREENS

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.

  • You can combine multiple Right Shoulders that possess different ‘Left Strengths’