Table of contents:
An SKS formation is one of the formations with the highest hit rate and the best risk/reward ratio. Why this is so, I will explain later in this article.
But first of all we need to understand what a shoulder-head-shoulder formation actually indicates. To do this, we first take a look at the classic course of a trend as defined by Charles Dow in his Dow Theory.
A classic uptrend consists of a sequence of rising highs and lows.
As long as this sequence continues, the trend remains intact. In the usual interpretation, an SKS formation is a trend reversal formation. It therefore represents a transition from an uptrend to a downtrend.
Let us look at a classic downtrend after Charles Dow:
If we now place these two trends next to each other, i.e. if we represent the change from an uptrend to a downtrend, the following chart emerges:
Without knowing it, we have already created an SKS formation here. It consists of four elements:
- Left shoulder
- Right shoulder
- Neck line
In the chart above, the highest high represents the head, while the two flanking highs to the left and right of the head represent the shoulders. The neckline is created by connecting the two lows to the left and right of the head.
The formation taken individually from the context then looks like the following masses:
This formation can be found, simply by the way it is formed, in all possible time levels. No matter whether you work in a 5-minute chart, hourly chart, daily or weekly chart, you will always stumble over the shoulder-head-shoulder formation.
However, the positive expectation value when trading this formation is only proven on the daily chart. In my experience, the shorter the time the formation is formed, the more false signals will increase.
Therefore, I recommend trading SKS formations only if they were formed on the daily chart and/or the weekly chart.
Practice with shoulder-head-shoulder formation
A prime example of a shoulder-head-shoulder formation emerged last year in the largest German stock index, the DAX. I had repeatedly referred to this situation in my newsletter and also in many webinars:
The following course has been exemplary after the breakout to the target area:
But how do you trade this formation?
This is how to handle an SKS formation
In the following 6 points I describe how I handle the SKS formation.
1. identify the trend
To be able to trade a trend reversal formation, we naturally need an intact trend. Above I have already described the simplest way of trend identification. Rising highs and rising lows result in an uptrend, falling highs and falling lows are part of a downtrend.
2. identify the shoulder head-shoulder-shoulder formation
Trend-following traders are constantly looking for sequences with rising highs and lows in the markets they trade, as shown in Fig. 1. A first sign of a possible trend reversal in the form of an SKS formation is now simply a situation where the price is no longer able to reach a higher high, but the attempt to reach a new high at about the penultimate high fails. Ideally, the duration of the training is also similar for the right and left shoulder.
3. planning the start and stop
The entry into a trade due to an SKS formation is usually made in the breakthrough of the neck line. Here, the daily chart also allows you to wait for the closing price to confirm a breakout.
The stop should not be too far away from the entry. After a break through the neck line, the movement should continue quickly. It is better to close a position quickly with (small) losses than to generate a very high hit rate with extremely long stops and then sit on high losses in the event of a loss.
At the latest when the price exceeds the high of the right shoulder again after the breakthrough of the neck line, the trade must be terminated, because the SKS formation has failed then.
4. plan the goal
The distance to the target of the trade should be greater than that to the stop for almost all trades. This automatically results in the trade earning more than it costs in case of loss. A well-tried method of target finding is to measure the distance from the high of the SKS formation to the neckline, and to put this distance on the breakthrough of the neckline. It is best to combine this target area, which is determined by the formation, with old support or resistance areas.
5. use volume for confirmation
In the ideal case of a chart formation, the trading volume increases when breaking out of the formation. This is also the case with a shoulder-head-shoulder formation. An increasing volume in the breakout can be used as additional confirmation for a continuation of the new trend direction. Similarly, a breakout can be waited for on a daily closing price basis before opening a position.
6. check for important news
Especially when trading individual stocks, traders should check before each trade whether important company-specific news is expected in the coming days. For example, traders should not position themselves immediately before the publication of company balance sheets.
However, a shoulder-head-shoulder formation can not only occur at the end of an uptrend, but can also end a downtrend as a so-called “inverse SKS formation”.
Here are two examples of inverse SKS formations (at Zalando and SAP), which I have been trading myself lately.