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 area 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.
To review the H&S pattern that has formed on Merck & Company’s stock, please take a look at the 1-year chart of MRK (Merck & Company, Inc.) below with my added notations:
MRK had been on a 5-month rally since its bottom in June. Over the last (6) months, the stock has created a very important level at $42.50 (red), which would also be the “neckline” support for the H&S pattern. Above the neckline you will notice the H&S pattern itself (blue). Confirmation of the H&S occurred when MRK broke its $42.50 “neckline” support. Also, notice the volume spike on the breakdown (pink). Volume increases on breakouts or breakdowns add validity to the break. So, the stock should be moving lower overall from here.
Keep in mind that simple is usually better. Had I never pointed out this H&S pattern, one would still think this stock is moving lower simply if it broke below the $42.50 support level. In short, whether you noticed the pattern or not, the trade would still be the same: On the break below the key $42.50 level.
The Tale of the Tape: After embarking on a nice uptrend, MRK confirmed its head & shoulders pattern. A short trade could be placed now, or should be entered on any rallies up to or near the $42.50 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