The potential downside for EUR/USD
I have been focused on the US dollar over the last couple of weeks. I was looking for EUR/USD to bounce above the mid-1.1600 area and I wrote last week:
‘[W]e should eventually move above here towards stronger 55-day moving average resistance at 1.1845/50.
This is likely to be the main obstacle to a recovery. Therefore a break above 1.1885 would be further bullish confirmation.’
However the pair topped at 1.1880, failing to make the next break higher for further bullish confirmation. This is a significant development with potential for a large move to the downside, as we may be forming the right shoulder of a head-and-shoulders topping pattern.
This brings me to a short technical analysis lesson. The head-and-shoulders pattern, while very simple, appears to be one of the most misunderstood patterns, according to the comments I read on Twitter at least.
Calling the head-and-shoulders top
The head-and-shoulders is a favourite pattern of mine. Not so easy to spot but when the pattern is confirmed it is quite reliable. This reversal pattern signals the end of a bull trend and a switch to a bear trend.
The important point to note, and one that is misunderstood by so many traders, is that the head-and-shoulders pattern is only relevant after a sustained bull trend. If you see the pattern forming in a sideways trend, or on a bounce in a bear trend, this is not a head-and-shoulders pattern.
All too often I see inexperienced traders and analysts calling the head-and-shoulders top after a very small move higher, or even worse after a period of downward-trending prices. This is not to say that moves to the downside will not be seen. It does, however, mean that the pattern has been completely misread.
How to read the pattern
In the example below you can see a sustained bull trend on the right-hand side of the chart leading up to the head-and-shoulders pattern formation. A bull trend is identified, as we know, by successive higher highs and higher lows. The head-and-shoulders pattern clearly demonstrate a breakdown of this trend.
The left shoulder gives no cause for concern as prices continue higher after the left shoulder peak. The pull-back of the left shoulder may or may not be lower than the previous pull-back. The head forms with a new high in the bull trend, but is followed by a significant sell-off, more than would be expected in a bull trend.
The base of the pull-back may be just above, equal to or below the base of the pull-back of the left shoulder. The lower the base of the pull-back, however, the more effective the head-and-shoulders is likely to be.
The right shoulder then gives the main cause for concern. The peak is below the head and may even be below the peak of the left shoulder. This signals the bear trend has ended and we no longer achieve new highs. We are now alert to a potential head-and-shoulders pattern forming but this could just be a sideways trend developing, so we must wait for confirmation. (Too many times I have traded this pattern, selling short before seeing confirmation, leading to a losing trade.)
Confirmation of the formation of the negative reversal pattern comes with a break below the neckline. The neckline is drawn by connecting the two low points of the two shoulders and extending the trendline to the left. Once the neck is broken, we have our sell signal. The price heads lower and quite often collapses sharply.
We can gauge a price target for the pattern by measuring the distance from the peak of the head (where the market topped out) to the low that followed (the start of the right shoulder). If you project this lower from the neckline, this gives you a measured target for the pattern. This target can be exceeded if the bear trend continues lower.
Note how the neckline then continues to act as resistance once the price bounces.
Focus on EUR/USD
Now let’s look at the current EUR/USD example. In fact this is particularly negative because we have a head-and-shoulders pattern within a bigger head-and-shoulders pattern. The left shoulder of the bigger pattern is formed in the first two to three weeks of August, as you can see in the chart below.
The head consists of another smaller head-and-shoulders pattern, with the left shoulder formed in the last week of August, the head within the first two weeks of September and the right shoulder in the third week of September. (In fact, this minor head-and-shoulders pattern did play out with the market seeking to breach Fibonacci support at 1.1680/1.1670.)
The question now is, are we forming a right shoulder in a bigger three-month head-and-shoulders pattern? The peak of the left shoulder is at 1.1909 and the pair topped just below last week at 1.1880. A right shoulder peak below the left shoulder peak is typical of this pattern. The price looks increasingly likely to re-test that important Fibonacci support at 1.1680/1.1670, which will now also act as the important neckline to this pattern.
It is only the break of the neckline that confirms the formation of the pattern and gives us our sell signal. It’s interesting to note that the blue 100-day moving average line is rising towards that neckline. Therefore a break below will have added significance.
Do not jump the gun and sell now in the hope of the pattern forming. In my 30 years of trading I have done this too many times and it has cost me dearly. In fact there is no harm in waiting for the pattern to form. You can watch the price break below the neckline and then wait to sell on a bounce to the neckline, which often happens. I will be watching carefully and will of course keep you updated.
Technical Analyst & Trader
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