Head and Shoulders Candlestick Strategy

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Video Transcription:

Hey, traders. We’re onto video nine of the Advanced Forex Strategies Course. In this video, we are looking at a head and shoulders strategy. We can use it on all timeframes. It’s brought to you by Investoo.com.

Trend trading is where the money is. There are multiple ways to trade trends. This is a reversal strategy. Evidence suggests that a new trend has begun, based on this pattern. As always, we want our reward to be greater than our risk, and we can use it on all timeframes. Trade in the direction of the trend. In this case, it is a probable new trend. The pattern itself adds evidence of a reversal, since it appears when trend momentum has already showed signs of a reversal.

With this strategy, we can set and forget. Once we have that entry point, we have set our stop. We have set our targets. We can just let math do the work. Let it hit your stop or target. So, a head and shoulders topping pattern is characterized by a swing high, a pullback lower, a higher swing high, a pullback, and then a lower swing high. This is how we get that transition in momentum from an uptrend to a downtrend. We’ve had that higher swing high. Now, we’ve had a higher swing low. So, we’re starting to collapse to the downside a bit, and we’re expecting that downside move to continue.

A neckline connects the two pullback lows. Enter short on a break below the neckline. We can also use a trend trading consolidation entry as the price drops toward that neckline. If we get a bit of a pullback higher again and get that consolidation pause, we can trade a breakout to the downside of that consolidation, since we already have some confirmation that a downtrend has begun.

Then, we can also take another entry at the neckline if we want. Stops go one pip above the right shoulder. Target is the height of the pattern, subtract from the breakout price. We want to be really conservative here. Don’t use extremes in price. It’s better to get out with a profit than to miss a target by one or two pips.

Risk must be kept below 1% on all orders. If we do end up taking two entry points, we still want to make sure that our risk is less than 1% on that trade. So, the head and shoulders bottoming pattern is characterized by a swing low, a pullback higher, a lower swing low, a pullback, and a higher swing low. Once again, we have that transition in momentum for making lower swing lows to higher swing lows. So, we’re starting to see some upside push in this, and we’re expecting that to continue.

A neckline connects the two pullback highs. The main entry is to just enter when we break above the neckline. Once again, if we do have a bit of pullback before that, and we get one of those consolidation breakouts that we covered in the trend trading video, then we can trade that as well. When we get that four-bar consolidation, a pop above it, we can go long.

One pip below the right shoulder is where we place our stop, and our target is based on the height of the pattern, added to the breakout price. Once again, we’re going to be conservative. I’ll show you how to do that. Risk must be kept below 1% on all orders. So, let’s look at a downside transitioning to an upside.

First, this would be a head and shoulders bottoming pattern. So, we have this, the left shoulder. We have this drop, a bigger drop. This is our head. We have a pullback. Move to a higher low. We can see we made a slightly higher low here. This low is higher than this. This is our right shoulder, and then we’re having this move to the upside. So, we have this neckline which connects the two pullbacks. There we go.

So, our entry point is basically right as soon as the price hits . . . goes above this neckline. We enter long. Once again, like other strategies, we don’t wait for bars to complete. Bars are arbitrary. We don’t care. This price could have run too far by the time, if we wait for a bar to complete. So, as soon as that bar pops above . . . the price pops above that neckline, we’re looking to get in. We place our stop one pip below this right shoulder.

As you can see, we have quite a bit of distance now between our entry point and this. That’s why we don’t need to put a five or six pip stop below this right shoulder, as we did with some of the other strategies. Basically we’re putting it right at that low, just a touch below. So, this box represents our risk then. We are getting in here, and our stop is down here.

Next, we need to establish our target. One way to do it quite easily is to just grab a trend line tool, and we are just going to use it to measure the height of this pattern. So, once again, we’re not going to use these extreme points. We’re going to use points where the market was able to reach it and close or open, basically the bodies of the bars, not just the little tail ends.

So, here is about where we want to be. So, you can see that little square marks the top of those. Along the bottom here, once again, we don’t want to use these extremes. We want to use a price where the bar . . . or where the market seemed to really respect it. So, we can see a number of times the bar is closed and opened at this level here. So, that’s the level we’re going to use instead.

As we can see, if we just compare that to our risk, we are still getting more profit than risk. So, we add that to the breakout price to get our target, and we can see it just barely reached it. That’s why I said we want to be very conservative with this. So, I’ll even normally knock off a few pips, just to make sure I get out. So, there we would have been able to get out with a couple pips to spare.

Like I said, this strategy, especially since we’re not using really any trend, I’ll trade these whenever I see them. We want to be conservative because the market does have a tendency, if we get too extreme with our profit targets, it isn’t going to make it to them. So, be conservative. Make sure that you get those pips because once we have that breakout, it’s a pretty high probability trade, in the sense that it’s going to move in our direction, but it won’t always move a ton in our direction. So, be conservative with the target.

So, let’s look at another one. This time, a downtrend, and it actually occurred right after this one. So, it will take a bit of practice to be able to spot these in real time. So, here we have a left shoulder, a pullback, a move up to the head here, a pullback, then a right shoulder. We pull back, make a lower high and a drop below. So, we would have taken this short right as soon as the price dropped through the neckline.

Once again, we’ll use this box to represent our risk. So, we would have been going short just below this neckline, and our stop is one pip above, so just barely above that last high. So, here . . . So, there is our stop level right here above that high, entering down here. Our target is going to be down here. Once again, we need to use trend line tools to establish the height of the pattern. So, we’re going from the high, but we’re not going to use the extreme. We’re going to use levels that were hit. So, this bar closed there. The next one opened. So, we’re going to use that level.

Then, down here, once again, we’re not going to use the extreme low. Instead, we’re going to use this area where we had a bit of consolidation to mark the height of our pattern. So, you can see the conservative is much smaller than the actual height of the pattern, and that’s fine. That’s what we want. If we compare even that conservative target to our risk, we can see we have quite a bit more profit potential than the risk, which is represented by this box, our profit target represented by the height of this line.

So, we would add that or subtract that from our breakout price, and we’d end up with a target right down here, as you can see near the bottom. If we would have got too aggressive, and our target was down here, we may not have gotten out. This is very common that . . . As I mentioned before, we want to be conservative, simply because the market will generally run in our favor, but it isn’t necessarily a full-blown trend reversal. So, we want to be able to get out and take our money, be on our way, look for other opportunities.

So, once again, if we use that conservative target, profit target down here, and we are easily out and looking for other opportunities. So, every trade has a stop and target. Put these orders out when you place the trade. Only risk 1% of your account in any one pair, even if you’re taking different entries. That way, even a string of losses won’t significantly draw down your account.

Take entries at both places. We didn’t cover that in this video. I’m going to cover another entry point in a future video, which is going to look at all these patterns. There is one other entry that we can use, but we’re not going to discuss that in this video because it’s a bit more advanced.

So, right now, you just have that one entry point on the neckline break. So, make sure that that entry is less than 1% of your account. Only trade in the trending direction. In this case, we were betting on a new trend, at least for the short term, based on the head and shoulders break. Place a stop one pip above the right shoulder for a topping pattern, one pip below the right shoulder for a bottoming pattern.

Target is the height of the pattern, and we add that to the breakout price for a bottoming pattern, subtract it from our breakout price for a topping pattern. Be conservative. I cannot stress that enough. Do not get ripped off for a couple pips, just because you went too aggressive. Use a conservative target. Add it. Even subtract a couple pips from it. As long as your profit is greater than your risk, and you can easily compare those two, you’ll be fine. So, just be conservative.

Trading involves substantial risk of loss. Only trade with capital you can afford to lose. Test out strategies before using them to make sure you can actually implement them and that they work for you. Looking at a few head and shoulder patterns on a video isn’t going to make you an expert. You need to find them, be able to spot them in real time, be able to put out your orders, draw the necklines, get the entries, set the stop, and also be able to set your conservative target and understand how those conservative targets are created. Until next time, happy trading.


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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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