Forget the Hindenburg Omen as a precursor of disaster; it's an unreliable pattern. The head and shoulder pattern is much more reliable and this has developed in the dollar-yen chart.
The pattern is created by a rally and retreat – the left shoulder – followed by a higher rally and retreat – the head – and then completed with a third rally and retreat – the right shoulder. The two low points in the shoulders are connected by a neck line. The pattern is confirmed when the price falls below the neckline and invalidated when the price rises above the peak of the right shoulder.
Since the onset of the global financial crisis occurrences of double right shoulders have been more frequent. These appear when the first right shoulder rally develops a retreat and then rebounds from the neckline to create a second rally that has a high that's about the same height as the first right shoulder rally. This delays the completion of the pattern but the analysis remains the same.
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We treat this pattern with a little more caution in currency charts because currency trading is driven by factors others than psychology. Up to half of the participants are in trades they really don't want to be involved in; when you settle a business deal in U.S. Dollars the bank must take the other side of the trade irrespective of their investment preferences. Patterns which are based on psychology are not as effective, but they still provide guidance. In this spirit we apply the head and shoulder analysis to the dollar-yen chart.
The head and shoulder pattern is a reversal pattern. In a stock chart or index chart the pattern is used to set a reliable downside target. In a currency chart we use it to warn of the potential for trend change rather than to set a downside target. In this case, the pattern suggests weakness in the uptrend.
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If we apply classic analysis the pattern suggests a downside dollar-yen target near 0.84. This is a long-term historical resistance level; it acted as resistance in late 2010 and for the first half of 2011, and it capped a strong rally in April 2012. The breakout above 0.84 in December 2012 was the confirmation signal of the strong uptrend that carried the pair to 103. Any collapse below the head and shoulder neckline would naturally use 0.84 as a major support level.
The most important upside level for the dollar-yen is 102. This is the most powerful support and resistance level on the long-term chart; it acted as a support level in 1994, 2000, 2005 and as a resistance level in 2009. This suggests that any breakout above 102 has an immediate upside target near 107.
(Read more: Dollar-yen at 102 (not 100) is more crucial: Charts)
The most important downside level is 0.96, the value of the neckline. A move below this level and a move below support near 0.95, has a long-term downside target near 0.84 but this must be applied with caution.
Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –www.guppytraders.com. He is a regular guest on CNBCAsia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe
