How to anticipate a market change
Increase your trading edge – use shoulders!
Let’s face it, not all rebound setups are created equal. Most of them are tricky, that would lure unsuspecting traders to play them out in a classic way, only to get whipsawed right before the beginning of the expected move.
Other potential rebound setups don’t end up quite as rebounds, but the market powerfully rams through the price level and never looks back.
To be profitable over the long-term trading rebounds, traders must have an edge, that would make their rebound setups stand out from the majority of noisy, dubious and other low-quality price formations that the market is usually filled with.
In this article, we will look closer at one of the signals, that distinguishes high-quality rebound setups. Read on to increase your win rate trading rebounds!
What are shoulders?
Almost any classic pattern has a confirmation element, the signal that provides the evidence of whether the market is really strong or weak. The confirmation helps us to identify the specific moment to open a position. Shoulders provide us with such confirmation.
Shoulders are a higher low in a downtrend or a lower low in an uptrend. Look at the basic example below.
Reading the price action is a skill
Usually, when we look at the schematic scratches of price patterns, it’s pretty straight-forward. However, when it comes to the real price action in the live market environment, it might get confusing, as for the untrained eye it’s challenging to identify any sorts of sequences in seemingly totally chaotic price action.
That’s why traders should focus on understanding the logic of how the patterns form, to avoid seeing setups where there are objectively none. Understanding the evolution of the price action, that leads to the certain patterns is essential to be able to recognize the setups in time, and be ready for the confirmation, before the confirmation has actually taken place.
In a hindsight, it’s pretty easy to see things just by scrolling back the price history. However, it’s a different story when we don’t see the right side of the price chart, and our decision or indecision can lead to potential profits, losses or missed opportunities.
How to identify shoulders?
Let’s learn to “read” the price action and understand how the shoulders form. Below is the sequence of how the markets form the shoulders. We will refer to the downtrend as the basic example, although the same principles apply for uptrends vice versa.
1. The market is in a downtrend. The price is approaching a certain price area, and bounces off it twice, forming the support zone.
2. At the support zone the market forms another low (marked with the grey arrow), and then retraces up from the support area. As the market retests the support area and fails to move further down, rebounding up from the support, we name such formation the Retest Fail.
3. After the market had bounced off the support area, we can expect the shoulder to form. If the downtrend forms a higher low than the one, that tested the support area previously, we call the higher low a shoulder (the price action in the rectangle).
4. How do we know if the last low is the real low or just a sort of market noise in a context of the downtrend retracement? The price should reach the local high of the up-move (the red line), that the market formed when it bounced off the support area in step 3.
How to manage the Shoulders-based trade?
To open a trade, we should have a specific reason, a trigger, that would prompt us to actually push the buy or sell button at a particular moment. In other words, the entry trigger gives us the timing advantage – the ability to get the best risk-to-reward ratio available for our trade.
When trading the shoulder pattern, one of the best entry triggers would be the breakout of the previous local high – the high of the move when the market bounced off the support area. In the example below, we would want to buy above the red line.
After the rebound-move made a high, that you suspect to be the part of the shoulder pattern (marked with the blue zigzag), wait until the market forms at least one rebound type or a neutral type candlestick pattern (Doji, hammer, spinning top, etc.). In the example below, a candle that’s in a rectangle is the hammer candlestick pattern.
Such a rebound or a neutral candlestick pattern (can be several candles) makes the higher low of the downtrend, indicating that the selling pressure is fading away and more buyers are stepping in.
Choose the order type
To open a trade, you can set a pending buy stop order right above the high of the rebound-move. Pending orders are good when the lower low is deep and might take time to recover by moving up, and you wouldn’t be able to place the market order manually being away from the computer.
If you’re ready to be fully engaged in the market in real-time, you can use the market buy order. One of the best ways to click “buy” is when the breaking out candle closes above the high.
In the chart above, the horizontal black line is the shoulder’s high – the key price, that we want the market to be above to place a buy order.
The relevance of the timeframes
If you use your main timeframe to buy at the breakout candle close, the probability of the up-move continuation would be the highest, however, you might enter later than you would, using the candle from a lower timeframe. Lower timeframes typically have a lower probability of the true breakout as there is more random noise in the price action.
Define your risk
A good spot to place your protective stop would be below the higher low of the downtrend, or below the support zone (marked with the red lines). Placing the stop below the higher low is considered to be more aggressive, increasing your risk-to-reward ratio but decreasing the win rate.
The stop below the support zone gives the market more space “to breathe” diminishing the chances of your protective stop to be hit, thus increasing your win rate and decreasing your risk-to-reward ratio, as the distance to the stop is bigger.
Shoulder pattern is a great indicator of a change in market sentiment and, eventually, the reversal of the trend.
The skill of understanding the logic of the pattern formation is the key to filtering out the real setups from the market noise and getting around as the market uncovers the setup in real-time.
Traders can use the shoulders to increase the win rate of the rebound setup and to pinpoint the exact moment of entering the market with the breakout. Shoulders offer a clear way to define the risk of a trade and provide two types of risk-to-reward ratio according to the trader’s risk profile.
Learn more about Shoulders here.