Talking Technicals with Christian Tharp, CMT – Chart Patterns

For those familiar with technical analysis and chart patterns, a head and shoulders pattern is probably not new to you. However, if you are newer to the markets you may be thinking, “What does shampoo have to do with trading stocks?” The name alone might even sound a little… hokie?!? Believe it or not, it is a real term in the field of technical analysis and it is the name of one of the more interesting chart patterns that can form on stocks.

Head and Shoulders

A head and shoulders pattern (H&S) is one of the more complex, but easy to recognize, chart formations that can appear on stocks. It’s a lot harder to describe an H&S with words than it is to just simply show one on a chart.

Head and shoulders are generally considered to be reversal patterns, meaning that they usually form at the end of a stock’s uptrend, and you can see where the pattern gets its name. Think of it as simply a topping process.

The one thing you have to remember is that for the H&S to have meaning, it needs to “confirm”. Confirmation is simply a break of the support, called the “neckline”, created by the pattern. The neckline doesn’t necessarily have to be horizontal as show in the diagram above; it can also slope up or downward. Once the neckline break occurs, the stock should continue to move much lower. If traders miss the initial breakdown, it is not uncommon to get a “retest” of the neckline support as a new resistance.

One more thing, H&S patterns can provide price targets. Simply take the height of the overall pattern and subtract that amount from the breakdown point to get the minimum price objective. Price targets are certainly not guarantees, but they are often fulfilled.

A great example of this formation is found on a stock that I noticed in one of my searches – MUSA (Metals USA Holdings Corp.). The company is within the basic materials sector, specifically the steel industry. If you look at my chart below, you can see that MUSA has formed an amazing example of a head and shoulders pattern.

We have all the necessary components in the pattern (green): The left shoulder? Check. Right shoulder? Check. Higher “head” in the middle? Yep. Neckline (red) support? All systems are a go! To boot, you can see that the stock has confirmed the pattern AND is now retesting the previous $13.50 support as a new resistance. The price target (blue) for the drop should get MUSA down to the $9.50 area.

Before making any trading decision, remember to consider which side of the trade you believe gives you the highest probability of success. For example, analyze the overall market to see which direction it is trending. Making this type of decision ahead of time will help you decide which side of the trade you believe gives you the best opportunities. Regardless of your strategy, or when you decide to enter, always remember to use protective stops and you’ll be around for the next trade.

Good luck and great profits!

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