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Old 12-06-2007, 02:46 PM   #1 (permalink)
 
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Strategy for Trading the Head and Shoulders Pattern


Previous Lesson

Practice Trading Head and Shoulders Patterns with a Free FXCM Forex Demo




In our last lesson we learned how to spot a head and shoulders pattern and a reverse head and shoulders pattern in the forex, futures, and stock markets. In this lesson we are going to look at a specific strategy that many traders use to trade these patterns.

Upon the break of the neckline support level the chart pattern is said to be in place so this is where traders will commonly look to enter a short position. Their target will be calculated by measuring the distance from the head of the pattern down to the neckline and then projecting that distance downward from the breakpoint of the neckline. The stop will then be placed just above the right hand shoulder of the pattern which is considered resistance. The idea here is that once the neckline support has been broken sellers will theoretically remain in control but if this does not happen then you are protected with a stop loss just above the nearest resistance level.

Example of the Head and Shoulders Strategy:


For the reverse head and shoulders the strategy is a mirror image of the above. Upon the break of the neckline resistance the pattern is said to be in place so traders will commonly look to buy at this level. Just as with the head and shoulders their target will be calculated by measuring the distance between the head and the neckline but in this case the target is projected upward from the break point of the neckline. The stop will then be placed just above the right had shoulder of the pattern which is in this case considered the nearest support level.

Example of the Reverse Head and Shoulders Strategy:


For confirmation, traders will commonly look for a downward sloping neckline before entering a trade on the break of a head and shoulders pattern and an upward sloping neckline before entering a trade on the reverse head and shoulders, as this is further indication that the trend is reversing. Secondly traders like to see the volume on the second peak (trough with a reverse head and shoulders) be lower than the volume on the first, and the volume on the third peak (trough in a reverse head and shoulders) be lower than the volume on the second peak as this is further confirmation that the trend is ready to reverse. Lastly they will look for increasing volume on the break of the neckline to show that the break is real.

Links to Help You Learn to Trade the Head and Shoulders Pattern

Head and Shoulders Top (Reversal) - StockCharts.com
Head Shoulder
Head and Shoulders stock pattern at Trade10.com- The science of trading market momentum for stocks, options, futures and bonds.
Kevin's Market Blog: The Head And Shoulders Reversal Pattern

That’s our lesson for today. You should now have a good understanding of the head and shoulders pattern and the reverse head and shoulders pattern as well as a trading strategy for each of them. In our next lesson we are going to finish up on reversal patterns by looking at the rising wedge and falling wedge patterns and then we will move onto continuation patterns after that.

As always if you have any questions or comments please leave them in the comments section below so we can all learn to trade together, and good luck with your trading!

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Old 02-01-2008, 03:10 PM   #2 (permalink)
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Stop Loss


Hello David,

It was quite impressive your videos. I am pretty new to trading and hence I have a small question. Why do you put stop loss at a lowest point of a trough(in head and shoulders pattern for long positions)?
Doesnt that mean you are giving room for a lot of loss?

Thanks
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Old 02-01-2008, 03:25 PM   #3 (permalink)
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Quote:
Originally Posted by Unregistered View Post
Hello David,

It was quite impressive your videos. I am pretty new to trading and hence I have a small question. Why do you put stop loss at a lowest point of a trough(in head and shoulders pattern for long positions)?
Doesnt that mean you are giving room for a lot of loss?

Thanks
Hi There,

Thanks for the note I am glad you like the videos. The stop is actually placed below the right shoulder of the pattern when going long off of a head and shoulders bottom. In this video that happens to also be in line with the top of the trough however this is not necessarily always the case.

The shoulder normally gives you a position in which to place your stop so that you are close enough to your entry point where the distance between the stop and your entry will be a lot less than the distance between the stop and your target price although I agree with you in this case it is a little large.

Keep in mind also however that the stop placement should be looked at in regards to how much profit you are targeting and how much of your trading capital you are willing to risk per trade more so than the distance away from the entry price as I talk about in my lessons on money management here.

Hope that helps. Let me know if you have any other questions.

Best Regards,
Dave
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Old 03-23-2008, 12:52 AM   #4 (permalink)
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Great Information!


Hi David,
I do not have access to real time quotes and I am new to investing. I would like to apply the head and shoulders strategy using daily quotes instead or a shorter time frame. Will this strategy work for any time frame or does it work better in some time frames rather than others?

Thanks!
-HM
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Old 03-23-2008, 11:55 AM   #5 (permalink)
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Quote:
Originally Posted by Unregistered View Post
Hi David,
I do not have access to real time quotes and I am new to investing. I would like to apply the head and shoulders strategy using daily quotes instead or a shorter time frame. Will this strategy work for any time frame or does it work better in some time frames rather than others?

Thanks!
-HM
Hi HM,

Thanks for the comment. In general I think most traders will tell you that the longer the time frame a pattern exists on the more relevant that pattern is.

Best Regards,
Dave
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Old 05-26-2008, 03:34 PM   #6 (permalink)
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Inverted HSN


Hello. I've been reading charts on a specific company. What I thought on a 1yr chart was an inverted HSN, was indeed the downtrend on an upright HSN on a 2yr chart.

For instance, what I thought was the left arm of the 1yr HSN was actually the right arm of the 2yr. The downtrend formed the inverted head.

My question is- is it possible for an upright HSN to have an inverted HSN follow it? Volume has been intact. I'm only needing the push on volume to finish the right arm & then neckline. That's currently where I am.

Could you please look at PAL? (North American Palladium)
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Old 05-26-2008, 03:59 PM   #7 (permalink)
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PAL


Sorry that was the name of the company in question.

I'm thankful for you, your Spirit & Patience. Not to mention your GENEROSITY
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Old 05-29-2008, 06:53 PM   #8 (permalink)
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Quote:
Originally Posted by Unregistered View Post
Hello. I've been reading charts on a specific company. What I thought on a 1yr chart was an inverted HSN, was indeed the downtrend on an upright HSN on a 2yr chart.

For instance, what I thought was the left arm of the 1yr HSN was actually the right arm of the 2yr. The downtrend formed the inverted head.

My question is- is it possible for an upright HSN to have an inverted HSN follow it? Volume has been intact. I'm only needing the push on volume to finish the right arm & then neckline. That's currently where I am.

Could you please look at PAL? (North American Palladium)
Hi There,

Thanks for the comment and my apologies for the long delay in reply I accidentally overlooked this post.

I am a little confused about what you are referring to as the arms of the pattern but in general a head and shoulders pattern is only valid if it is at the top of an uptrend and an inverse head and shoulders pattern is only valid if it is at the bottom of a downtrend.

With this in mind I see an inverse head and shoulders on the chart you mention which I have drawn below. I do not however see an upright head and shoulders pattern.

If there is something that I am missing here if you could post a chart of what you are looking at as I have done below that would help me get a better idea of what the line of thinking is. There are instructions on how to do this here.


Hope that helps. Feel free to post if there are any other questions or comments related to this.

Best Regards,
Dave
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Old 05-29-2008, 07:27 PM   #9 (permalink)
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Hi Dave! This is where I see an upright HSN on the 2 yr chart. Please direct me where I am mistaken.


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Old 05-29-2008, 07:38 PM   #10 (permalink)
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Hi,

Thanks for posting the image I see what you are talking about now. While this is what an upright head and shoulders pattern looks like the key here is that the pattern that you have denoted in the chart is at the bottom of a downtrend. I think most would agree that a head and shoulders pattern is only a valid pattern when it is found at the top of an uptrend, so the fact that this one is not negates the pattern. This is because the head and shoulders pattern is a reversal pattern not a continuation pattern.

Hope that helps.

Best Regards,
Dave
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