Forex Charts Book. Series of Free Forex ebooks

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Head-and-shoulders or a Crown

Head-and-shoulders pattern is a very popular pattern to watch for. Many traders like this pattern because it is easy to spot, it has very high rate of success and offers significant profit opportunities.

Head-and-shoulders pattern is also called a Crown Pattern. A crown is easier to imagine...
Head-and-shoulders can be almost always found on daily charts. This pattern tends to give more accurate results on larger time frames (weekly, daily or hourly).

Pattern indicates a potential reversal in the market.

Let's take a look at the chart below:

Crown formation becomes clearly visible when the price fails to make a new High (point 6 on the picture above) and instead stops and reverts at earlier High (point 2) level.

The chart at that particular moment looks next way:

This chart formation signals that Buyers cannot push the price any further to hold the uptrend and now it seems that sellers are behind the steering wheel.
When price is unable to make a new High it is a signal for a possible trend reversal.

The picture on the chart starts to look like a Crown.
When traders first spot the pattern they try to find a neckline. Neckline is found from previous support levels: these are point 3 and 5 on the chart. But, there is also point 5a, which is a support level too — found a little bit later as the pattern unfolds.
Traders may use either point to draw a neckline and get ready for action.
Further actions are simple: once the neckline is broken everybody jumps in for a nice ride.

However, there is another group of traders who seems to know some secret, because they were able to get in that particular trade long before everybody else even started thinking of trading that day; they were already gaining pips and, in fact, their money management is going to be much better when it's time to compare with those who is still waiting to get on board at the break of the Crown's neckline.

These "other" traders simply use a trend line to guide them through market price changes.
The beauty of a trend line is that it sensors a trend reversal much earlier than it can be actually spotted by a trader who does not use this tool.

This is what traders who use the trend line saw on the same chart that day:

Thier trend line is broken and when market again resumes its uptrend, not only does it find resistance at the earlier swing High it also hits against the trend line, which now acts as resistance.

There are two rules about trend lines that must be mentioned here:
1. Once trend line is broken it is a signal for a possible trend reversal.
2. In the bearish market an uptrend line acts as support, but once it has been broken, it is no longer a support but a new resistance line. (An opposite is true for bullish market where trend line represents a resistance level, but once broken it becomes a new support).

Returning to the Crown Pattern we can now understand the advantage of a trend line signal as it gives traders much earlier start/entry.

Regarding money management mentioned earlier: an entry at the re-test of the trend line also gains an advantage over the regular entry at the neckline.
According to the trend reversal rules, protective stops should be placed above the previous Swing High; in our case it is point 4 — a tip of the Head of the Head-and-shoulders pattern.
When entering at the neckline's breakpoint this Head and its Swing High will be much further (comparing to the trend line entry) and thus protective stop will be much wider.

Exit methods for the Head-and-Shoulders Pattern are:

1. Using a trailing stop. Since the price most of the time drops like a rock once the pattern has been spotted and everybody "has jumped in for a ride", traders can easily follow price moves and adjust their stops with each new progress made.
2. Using calculations based on the theory that the price after breaking a neckline is going to travel the amount of pips equal to the distance between the head's highest point and the neckline.

An upside-down Crown Pattern quick review:

Note: there may not always be a chance to enter at the re-test of the trend line — sometimes market just has no "strength" to reach there; then use a neckline for a regular entry.
Just remember: do not make up a pattern when it is not there. Trade what you see, not what you would like to see.

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