By: Christian Tharp, CMT
Traders spend a lot of time talking about chart patterns. Just watch enough CNBC, and you’re sure to see some complex or interesting or just downright silly patterns emerge. (One of my favorite ridiculous patterns is the famed “Vomiting Camel.”)
But the reason chart patterns are so widely talked about is because good patterns can serve as signals for which direction a stock will likely move in. Recognizing particular types of chart patterns can lead to a winning trade.
Being familiar with chart patterns is yet another skill every trader should develop. In fact, recognizing and following price action is one of the six important fundamentals I teach to my trading students.
Once you are able to identify short-term price action using a few key patterns and levels, you are better able to predict what a stock price will do. And that’s how you make money trading.
Now, remember… no chart pattern is perfect, and no chart pattern is 100% reliable every time. It’s possible for a stock to form a pattern that doesn’t follow through in the end. But the pattern we’re going to look at today is one of the more popular — and widely followed — patterns that professional traders look for.
The Head-And-Shoulders Pattern
In technical analysis, a head-and-shoulders pattern describes a specific chart formation that predicts a bullish-to-bearish trend reversal (when a stock that has been climbing is about to start falling).
The head and shoulders pattern is believed to be one of the most reliable trend reversal patterns. It is one of several top patterns that signal, with varying degrees of accuracy, that an upward trend is nearing its end.
Over the past few weeks, we’ve seen a textbook example of a head-and-shoulders pattern forming in Apple (AAPL). In the figure below, you can see the development of this pattern and trend that follows it. I’ve gone ahead and labeled the important features to make them easy for you to recognize.
A head-and-shoulders pattern is a chart formation that appears as a baseline (Support Line) with three peaks, where the outside two (Shoulders #1 and #2) are close in height and the middle (Head) is highest.
In terms of price action, each of the three peaks (Shoulder #1, Head, and Shoulder #2) signals a runup to a resistance level where it is then rejected, sending shares lower. This happens because no one is interested in buying the stock at this higher price, so it falls back to a level where people want to buy.
Often, when we see a stock fail to break through resistance multiple times in a row, it means investor interest just isn’t there. After enough rejections, the buyers fade out, and the once bullish stock begins a trend lower.
Using The Head-And-Shoulders Pattern For Market Timing
When we’re watching a head-and-shoulders pattern, we want to pay close attention to the formation of Shoulder #2. That’s where we want to set up our trade.
Once the stock’s price is rejected a third time and the second shoulder is fully formed, the price will commonly fall through that level of support and experience a short-term bearish trend. This gives us an opportunity to put on trades that would capitalize on this reversal in the trend.
To find a potential head-and-shoulders pattern while it’s forming, you simply need to look for a stock that has (1) already formed two tops and (2) is starting its third move up. If you are able to identify this pattern, you could then look to profit from the down move by buying puts on the stock while the second shoulder is forming.
As we can see in the figure above, once Apple’s price fell through the support line, the price saw a precipitous short-term decline. In this case, the value of AAPL puts would have increased as the stock’s price fell.
Once I see a pattern like this form, I like to zoom out and look to the broader market for some kind of confirmation of a larger downward trend. In this case, there was. During the formation of the second shoulder, the broader market was also undergoing a significant downtrend.
This kind of secondary confirmation is something we would look for in order to gauge the probability of the trade being a profitable one.
It is important to note that even though this can be a reliable indication of price action, this is only a signal of a shorter-term movement and does not predict where the price is going over the long term.
Recognizing these chart patterns can lead to more profitable trading, and it’s precisely the kind of skill my students and I go over every week in my live trading events.
This chart pattern is just one of a few key patterns and levels that I follow, and it isn’t every day a stock gives you a setup like this. That’s exactly why it is so important to familiarize yourself with patterns and price action so that you’re ready to strike when an opportunity presents itself.
Developing these skills takes time. Believe me, I know. As a CMT, I’ve spent the better part of 14 years studying these kinds of patterns both theoretically and in practice. Many of you don’t have hours to continually scour the market for chart patterns and setups, that is exactly why I’m here.
I want to share my knowledge and experience with my students so that they can be better prepared for their next trade. In my trading service, The Profit Machine, I offer a weekly live trading event where I review patterns with my students, discuss the state of the market, answer questions, and even place trades.
Don’t take on trading alone, let’s work together as a team and get your trading started off on the right foot. Don’t let inexperience or anxiety keep you on the sidelines any longer.
For more detail about Apple’s recent head-and-shoulders pattern, check out my video below!