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Not every chart pattern you trade will be profitable, but you will always know your downside and upside before you enter; so you can skip the trade if you don’t like risk vs the reward, writes trader Cory Mitchell of VantagePointTrading.com.

Chart patterns are a very useful tool because they occur regularly—providing you with lots of trade candidates—and also provide everything you need to trade. When you spot an ETF chart pattern, and know how to utilize it, the pattern provides you with an entry point, stop-loss price as well as a profit target. While no strategy is perfect, and chart patterns don’t produce a profit all the time, learning to use them in your trading can greatly enhance your ability to analyze and profit from ETFs.

The head and shoulders is a topping pattern, signaling an uptrend is likely over and a downtrend is commencing. The pattern is created when the price rises (left shoulder), then dips, rises again to a new high (head), declines, and then rallies again but not as high as the previous rally (right shoulder).
Usually the left and right shoulder will reach similar heights, although in the real-world these levels may vary marginally from one another.

The SPDR Select Sector Financial ETF (XLF) created a head and shoulders pattern in early 2011, and ultimately foretold of a significant top in the ETF.

Figure 1: Financial Sector ETF – Head and Shoulders Pattern
Click to Enlarge

That the right shoulder is lower than the head shows the market is losing momentum, but the pattern is not complete until the price moves below the neckline or the breakout point. The neckline is a trendline connecting the lows of the pullbacks, also called “armpits.” The breakout point is simply the lowest point in the pattern. Either can be used as an entry point—when the price drops below either of these levels it signals a further decline.

Once a trade is made, a stop loss can be placed just above the right shoulder to limit. The total height of the formation—the top of the head minus the lowest low—can be used to establish a profit target as well.

The high of the formation in figure 1 is $17.20 and low between the head and right shoulder is $16.24, therefore the height is $0.96. The height is subtracted from the low point of the formation to get a profit target: $16.24 minus $0.96 to get $15.28. In this case, the market fell much further than the target price.

While the pattern can be used to enter short trades, it is also a warning to those that are long that a correction is likely coming.

NEXT PAGE: Two More Important Patterns