A Head and Shoulders (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 (left shoulder). Next, the stock will rally again, but this time to a higher peak (head) than the previous one. After forming the head, the stock will pull back to the same support that the first shoulder did. Finally, the stock rallies a 3rd time, but not as high as the head (right shoulder). 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.
H&S patterns can also form upside-down after a downtrend as well. This pattern would be called an Inverse Head and Shoulders pattern. It too would be considered a reversal pattern and the neckline would be a resistance rather than a support.
To see such a pattern potentially being formed, please take a look at the 1-year chart of WLT (Walter Energy, Inc.) below with my added notations:
After moving lower for the entire year, WLT has almost formed what appears to be an Inverse H&S (blue). I have noted the head (H) and the shoulders (s) 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.) WLT’s “neckline” is at the $40 level (red). WLT would confirm the pattern by breaking up through the $40 resistance, and if it does, the stock should be moving higher from there.
Keep in mind that simple is usually better. Had I never pointed out this Inverse H&S pattern, one would still think this stock is moving higher simply if it broke through the $40 resistance level. In short, whether you noticed the pattern or not, the trade would still be the same: On the break above the key $40 level.
The Tale of the Tape: After a long downtrend, WLT seems to have formed an Inverse Head & Shoulders pattern. A long trade should be entered on a breakout above the $40 level with a stop placed under 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