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German DAX Head & Shoulders chart pattern

The Dax is looking very toppy, and the daily 200-period EMA is not offering decent support. In fact, the 200 EMA is flattening off and the price action is forming lower swing lows and possibly lower swing highs. This is a market we should watch because it is generally very closely aligned with the US DOW and other major markets.

Technical Analysis – German Dax

In technical analysis, the head and shoulders (H&S) chart pattern is illustrated by a baseline with three peaks, the middle peak being the highest. This head and shoulders chart pattern is supposed to indicate a trend reversal from bullish to bearish and signals that the upward trend is or will be ending. For a reversal of a bear trend, there is an inverse head and shoulders (IH&S) pattern.

All traders can use the pattern since it appears on all time frames, but the higher the time frame the more chance you have of any technical pattern working. The chart pattern provides important and easily recognizable entry levels, stop levels, and price targets, making the formation easy to trade. For a short, you wait for the neckline to break and then place your stop above the RHS or head, with a target 1x to 2x the distance from the head to the neckline.

My problem with chart patterns is that the human brain is designed to recognise patterns, and we see them when they don't exist. Pareidolia is the scientific name for this. Pareidolia is the tendency to perceive a specific, often meaningful image in a random or ambiguous visual pattern. Traders that put too much meaning into these random and ambiguous chart patterns are doomed to failure.

Another problem I have with the H&S pattern is that it is so obvious that I feel the institutional traders can manipulate the order flow enough to build a pattern, knowing that entries, stops and targets will be placed and therefore liquidity pools will form.

Head and Shoulder patterns happen all the time and generally, they are continuation patterns and in my humble opinion, it is because they do not often predict the top of a move. When a trader sees the pattern and places their stop above the RHS, 90% of the time I try and wait for a bullish entry and target those stops.

However, when we have had a massive bull run with very little in the way of corrective moves and the underlying fundamentals change and become more bearish, the H&S pattern takes on more meaning.

The right shoulder is formed when the bears start selling into the latecomer's bullishness. The bears, and probably more informed traders, use the new buy orders coming into the market to ditch their own long positions and flip to being sellers.

The signal for a proper H&S for me is when the neckline is sloping downwards showing new lower swing lows. With the RHS then showing a lower swing high. When the price action seems to be trading under the daily 200 EMA as much as above this shows momentum is slowing and possibly flipping. When the macroeconomics is pointing to a bleaker future there is less to prop up the market fundamentally or technically. The pattern then becomes a self-fulfilling prophecy.

The German DAX is currently indicating a possible H&S pattern and I would say this has a good chance of completing to the downside. Whether we could get all the way down to 11820 is up for debate but a decent move to 13800 or maybe as far as 13350 is a reasonable downside target. Especially if the US indices drop as far and fast as I have been calling for.

I would be tempted to add to my short if the price action does get down to the neckline, but not before seeing a decent rejection of the break of that neckline. The stop would be above the short-term swing high rather than all the way back to the RHS or Head since that drawdown would be too much to tolerate. You could, alternatively, expect lower lows in the future, so you may want to get in on a short earlier, put your stops above the swing high and hold for a test of the neckline, then reassess whether to keep holding for lower lows. But that would be when the pareidolia has taken preference for confirmation of a technical bearish trend.

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