It is nearly impossible to discuss chart patterns on stocks without eventually discussing the very common Head and Shoulders (H&S) pattern. An H&S pattern is a reversal pattern that forms after an uptrend. A textbook H&S pattern starts to form when a stock rallies to a point and then pulls back to a particular level (shoulder #1). Next, the stock will rally again, but this time to a higher peak (head) than the previous shoulder. After forming the head, the stock will pull back to the same support as the first shoulder did. Finally, the stock rallies a 3rd time, but not as high as the head (shoulder #2). The level that has been created by all 3 of the pullbacks is simply a support level referred to as the “neckline”. The formation of an H&S pattern warns of a potential reversal of the uptrend into a possible downtrend.
As with any chart pattern, a trader will usually not want to act on the pattern until the stock “confirms” the pattern. Confirmation is the break of the key level that has been created by the pattern. In the case of an H&S, confirmation would be when the stock breaks the neckline.
What a lot of newer traders do not know is that H&S patterns can also form upside down after a downtrend. This pattern would simply be called an Inverse Head and Shoulders pattern. To see such a pattern, please take a look at the 1-year chart of TSO (Tesoro Corporation) below with my added notations:
After a 3-month trend lower, TSO had formed what appears to be an Inverse H&S. I have noted the shoulders (S) and the head (H) to make the pattern more visible. (For future reference, if you imagine this pattern flipped upside down you would have a regular H&S pattern.) The neckline that TSO’s Inverse H&S formed is at the $25 level (green). Earlier this week, TSO confirmed the pattern by breaking up through the $25 neckline, thus the stock should be moving higher.
The one drawback to this setup is that traders would usually like to see volume spikes on breakouts, which TSO’s H&S breakout didn’t really have. Sometimes light volume on breakouts can be a precursor to the stock pulling back below the breakout level, thus creating a false breakout. So, always remember to use a stop!
Lastly, keep in mind that simple is usually better. Had I never pointed out this Inverse H&S pattern, one would still think the stock is moving higher simply because it broke through the $25 resistance level. In short, whether you noticed the pattern or not, the trade would still be the same: On the break above the key $25 level.
The Tale of the Tape: After a short downtrend, TSO formed an Inverse Head and Shoulders pattern and confirmed the pattern earlier this week with the break above the $25 neckline. The stock should be moving higher from here, so a long trade could be entered anywhere near the $25 level with a stop below that level.
Before making any trading decision, decide which side of the trade you believe gives you the highest probability of success. Do you prefer the short side of the market, long side, or do you want to be in the market at all? If you haven’t thought about it, review the overall indices themselves. For example, take a look at the S&P 500. Is it trending higher or lower? Has it recently broken through a key resistance or support level? Making these decisions ahead of time will help you decide which side of the trade you believe gives you the best opportunities.
No matter what your strategy or when you decide to enter, always remember to use protective stops and you’ll be around for the next trade. Capital preservation is always key!
Christian Tharp, CMT