The Head and Shoulders price pattern is one of the most well known patterns in trading. Its popularity is likely due to its visual simplicity.

The pattern is easy for even the amateur eye to spot, and it has a logic that contains a seemingly self-evident reasonableness: Price has been going up making higher highs, and then it makes a lower high. It makes sense that this price pattern would be the first sign that the direction of the market is about to reverse.

However, as with most things in trading, what seems obvious and self-evident to the retail (read: "amateur") trader is precisely and exactly the wrong thing to do!

The pros do what doesn't "make sense" to the amateurs.

The Head and Shoulders pattern provides an excellent example of this disparity between what the pros and amateurs look for in a price pattern, which, in turn, causes them to do very different things -- often taking exactly the opposite side of the market from each other.

In this article, I'll be using the example of a Head and Shoulders pattern, but everything I say applies to a Reverse Head and Shoulders pattern as well (just flip everything upside down).

These principles apply to any market (equities, futures, Forex, and so forth) and any time frame (day trading, swing trading, investing). For this reason, I'm not identifying the market price or time on the charts in this article -- it simply doesn't matter for the purpose of this discussion.

In the first chart, we have an example of the beginning of a Head and Shoulders price pattern. We are looking at it on the hard right edge of the screen, because that's where we trade.

Price has made a higher high followed by a lower high.

Question: Is this a good time to go short based on a Head and Shoulders pattern?

Answer: No.

Look at the second chart. You will see that the market did not reverse and go down. One reason for this Head and Shoulders "failure" is that this pattern was not actually a Head and Shoulders pattern at all.

Here's why:

A Head and Shoulders pattern is a REVERSAL pattern. You can't have a "reversal" until you've had a dominant and significant trend.

Remember the well-known adage: "The trend is your friend."

...and by extension: "The trend is your friend...until the end."

So, if we are looking for a reversal in the market, it makes sense to look for it only when the trend is no longer our friend.

Therefore, simply looking for a higher high, followed by a lower high, is not enough to identify a price pattern as a Head and Shoulders. The first qualification of the price pattern is that it must follow an established trend. (I look for a minimum of 2 retraces in the trend.)

Looking again at the first chart in this article, you'll notice that the market was not in a significant uptrend before the Head and Shoulders pattern formed.

However, when I'm looking for reversal trades of any type, I generally want to wait until there is not only an established trend, but an extended trend.

As traders, we need to be patient and wait for the odds to be on our side. Taking a reversal on an average trend (which I define as 2 retraces) puts me in the middle of the statistical odds. I'd rather trade from statistical extremes. In this case, that means that I want to trade when the trend is extended beyond an average length so that those still trading with the trend are now bucking the odds.

W.D. Gann was famous for saying that time is more important than price.

It took me a long time to appreciate that insight, but when I finally did, it changed my trading forever.

One of my mentors, a floor trader at the CME, said something similar, "Amateurs are usually right...at the wrong time."

As soon as he said that, I knew exactly what he meant because I'd felt that way so many times myself. I would get into a good-looking trade, only to have the market turn against me and take out my stop. Then, it would immediately go back in the direction of my original trade!

Sound familiar?

I was right...but at the wrong time!

Price patterns alone are not enough upon which to base a trading decision. Where that price pattern occurs on the chart and when that price pattern occurs are elements absolutely crucial to determining the probability of the price pattern delivering the desired results.

In the case of the Head and Shoulders, part of the equation of "when" is after an established trend.

Let's look at another scenario.

In this third chart, we have an example similar to that in the first chart. Again, we're looking at the hard right edge of the chart because that's where we have to make a decision to trade or not to trade.

This time, however, the higher high and lower high is preceded by an up trend. Therefore, we can say that, at this juncture, the TIME to look for a reversal in the form of a Head and Shoulders may be right.

So, should you take the trade and go short?

What if I were to tell you that some professional traders would look at this same chart, and it would prompt them to get ready to go long?!

Well, this is absolutely true! This is a great long setup, and I'm one of those guys who looks to take these patterns all the time. In fact, it's one of my favorite long setups.

In Part 2 of this article, I'll explain exactly why the pros would look to go long at this time on the chart and how you can align yourself with the pros on trades like these.

*Reprinted (and modified) with permission from Dr. Barry Burns, whose background and expertise include working with a former floor trader at the Chicago Mercantile Exchange, being the featured speaker at DayTradersUSA, developing a 5-day course for WorldWideTraders and headlining as a guest speaker for the Market Analysts of Southern California, giving seminars around the country at many Wealth Expos and being interviewed on the Robin Dayne "Elite Masters of Trading" Radio Show

How Pros Make Profits Head and Shoulders above the Amateurs...and You Can Too, Part 2 By Dr. Barry Burns of TopDogTrading.com Posted: Jan 30, 2009

In Part 1 of this article, we outlined some of the distinctions you can look for in a Head and Shoulders pattern beyond the simple higher high and lower high that most retail traders fixate on.

We pointed out that the pattern should occur after an established uptrend (with a minimum of 2 retraces) and, preferably, after an extended trend.

I left you with an example of a potential Head and Shoulders pattern (see the third chart in the Part 1 article) and asked if you would execute a short trade on that pattern. But, then, I left you with a cliffhanger, saying many pros would actually be looking for a long trade in that situation.

Now, look at our fourth chart in this two-part series to see what happened from there.

What looked like a Head and Shoulders pattern turned into an ABC complex retrace, and, then, the market continued the trend to the up side.

How did the pro know this would happen?

First, let's be clear on one thing. The pro didn't "know".

No one knows the future of what any market is going to do. The only thing the pro knows is that the market can do anything at any time.

But, the pros play the probabilities, and trend continuations are more likely than trend reversals.

Generally, trend trades have a better win / loss ratio, and trend reversal trades have a better risk / reward ratio.

The pro could also be looking at other factors, such as the next higher time frame and the momentum of the trend.

Or, the pro may actually have taken a short on the Head and Shoulders pattern, but being fully aware that this trade could turn into an ABC retrace and continue the trend, he / she could have been watching for that and stopped and reversed the position when it happened.

Flexibility is the hallmark of the professional trader.

But, there was one more clue that the trend could actually continue rather than reverse...

Many amateur traders only look at the highs when trading Head and Shoulder patterns. They are focused on the higher high and the lower high. But, they ignore the lows, and that's a huge mistake.

It's the lows that tell the real story and give insight into the psychology of what people are most likely to do in a Head and Shoulders pattern.

Notice that, in the third chart in Part 1 (reprinted at the beginning of this article), price not only made a lower high, but that lower high was preceded by a lower low.

That may seem favorable for a short. After all, isn't that further confirmation that we're beginning a new down trend?

The answer is more elegant than that.

Beginning traders using technical analysis are too enamored with the price patterns themselves as though there is some magic to them. There is no magic. The only reason certain price patterns provide probability scenarios for trading is because of the psychology behind them.

Remember: It's people who make the markets move up or down, and those movements are based on their trading positions, fear and greed. Price patterns are merely representations of traders' behaviors.

Here's how it works with a Head and Shoulders pattern.

The market has been in an uptrend, so a lot of people are in long positions. It's natural for many of those traders to place their stops below the previous low.

If the market makes a lower low, before it makes a lower high, many of the traders who were long are now out of their positions. They are comfortable because they have locked in their profits. This makes it less likely that the market will have a quick and dramatic fall from the lower high that is put in after that. People aren't "stuck", and this lessens the fear and emotional selling that would otherwise occur.

In contrast, if the market makes a higher low, and no one is stopped out, and, then, it puts in a lower high and you enter short, you are now in a position to potentially capture a fast and dramatic move down.

If the market then proceeds to take out the previous low, you are now in BEFORE any of the longs got out. They are trapped.

The key is that you want to get in early, before the longs are able to relieve the pressure of being on the wrong side of the market. You want their emotion to drive the market down after you get in, not before you get in.

People being stopped out triggers sell orders. In addition, there will also be people who are shorting when those support levels are broken. Again, you want to be in before those "breakdown traders".

Each successful low being broken brings in more selling that can continue to drive the market down further and further. Now, you're in a downtrend, but you got in before that down trend began. The risk / reward on this scenario (given that you maintain at least part of your position through the new down trend) is phenomenal.

Chart 5 shows one more interesting insight into this pattern that adds to the potential for a dramatic reversal pattern and the creation of a new trend in the opposite direction. When a Head and Shoulders forms in this way, it is a pattern within a pattern.

The higher low and the lower high form a triangle at the top of a trend. This can have 2 ramifications:

1. After a trend in which there may be high volatility, a triangle pattern is a low volatility pattern. This plays into one of the cycles of the markets: They alternate between high volatility and low volatility periods. Getting in during a low volatility cycle (such as a triangle) may allow you to be positioned before a major impulse move when the high volatility cycle begins again.

2. Institutions and big money traders cannot enter and exit positions quickly because of the size of their positions. If they execute a trade with their entire position at once, it moves the market too fast, and they don't get the price they want on all of their shares or contracts.

Therefore, at the top of trends, they use "distribution" techniques with which they sell small portions of their positions so as not to move the market. Thus, they are able to sell most or all of their position at a high price. This causes the markets to consolidate at these levels before they turn...and one of these consolidation patterns can be a triangle. So, by entering during a triangle, you may be potentially positioning yourself with the big money players.

Price patterns can be a very powerful tool in your trading plan if you don't just blindly trade the patterns, but you understand and trade the psychology and trading behavior that causes the patterns.

Remember that price patterns are not enough for trading success. They are just one element of a comprehensive and well crafted trading plan, along with looking at the other "energies" of the market, such as momentum, volume and the next higher time frame. And, all of this must be crowned with impeccable money management.