Learn to Trade Options: Trading the Head-and-Shoulders Pattern

One of the most popular patterns used by technical traders is the head-and-shoulders (H&S) formation. The pattern is fairly easy to describe. A stock (or other investment vehicle) will first peak and then decline to an area known as the neckline, forming the first (or left) shoulder. It will then bounce from the neckline to an even higher peak -- the head -- before returning to the neckline. Then, the equity will rally to another peak (but lower than the head) and subsequently return to the neckline, forming the second (or right) shoulder. At this point, the stock may be vulnerable to a sharp break south of the neckline.

As you can see on the chart above, this is a bearish pattern. However, there is a bullish equivalent called the inverse H&S -- just imagine the chart above turned upside-down.

Of course, there's plenty more to say on the H&S. To help flesh out the intricacies of this technical pattern, I asked Schaeffer's Senior VP of Research Todd Salamone for his thoughts on how to trade the H&S.

• There's oftentimes noise when attempting to discern an H&S pattern. At what point would you consider an H&S pattern to be "confirmed"?
  
  In a head-and-shoulders pattern, there is a neckline that is defined by a level that has held at least two times on pullbacks, otherwise known as support. In an inverse head-and-shoulders pattern, the neckline would be a resistance level. I look for confirmation when the neckline, or support/resistance, is finally broken.
  
  I prefer to see volume on the neckline break as healthy -- not climactic, but not extremely low either. If volume is suspect, I will look for a re-test of the former support/resistance level, known as a "throwback" move. During a "throwback" move, I am looking for a  successful hold of the support or resistance level. Finally, necklines can be slanted (see chart above) or flat. Slanted necklines will have three or more low or high points within the pattern in which you can draw a straight line. 

• What are the risks when trying to trade an H&S?
  
  As a trader with a contrarian mindset, I think one of the biggest risks that I've observed over the years with respect to a head-and-shoulders pattern -- and this would apply to all popular technical patterns -- is getting into a crowded trade when the pattern is obvious to everyone. I will monitor news and social media to get a hint as to whether or not a developing pattern is on the radar of multiple or only a few traders.
  
  Since the head-and-shoulders pattern is well-known by most technical traders, I have noticed that when the crowd has a cautious tilt on a widely followed asset, they will more easily see and possibly act on a bearish head-and-shoulders patterns. Moreover, I have observed that they are less apt to identify and act upon a bullish inverse head-and-shoulders pattern when that same cautious mindset is prevalent.
  
  Therefore, the risk is getting into a crowded short trade that might, at best, work well for a few hours or a few days -- but get wiped out in the blink of an eye. At worst, the asset immediately reverses back above the level that was breached, immediately generating short covering -- particularly in gap situations when stop-losses get triggered.

• Is there any way to predict the magnitude of a stock move following an H&S?
  
  The typical target is measuring the distance from the head to the neckline. The neckline plus (or minus) this distance establishes your target. This target is a guideline, though, not an absolute.

• Late last year, you highlighted a potential inverse H&S for the S&P MidCap 400 Index (MID). Did that materialize?
  
  Yes, I pointed out the potential for an inverse head-and-shoulders pattern in December 2014. By the way, this is something that no one was talking about in social media or other media.
  
  A pullback to 1,270 (the head) in October 2014 was sandwiched between two other pullbacks (the shoulders) to the 1,370-1,380 area that occurred in August and December. In early 2015, the pattern materialized when the MID broke above its 2014 highs (the neckline) in the 1,450 area. The target for this pattern is 180 points (neckline minus head) above the neckline, or 1,630. 

• Have you or others noticed any potential H&S patterns among the major indexes or big-name stocks?
  
  The S&P 500 Index (SPX) presents an interesting situation. In late June, a potentially bearish head-and-shoulders pattern was being observed by many technicians with the May highs in the 2,135 area sandwiched between prior highs around 2,125 in April and late June. The neckline was in the 2,070 zone, creating a target objective of 2,005. The neckline was broken in late June, with the SPX subsequently moving down to 2,040 on July 8, before a snap-back rally back above 2,100 and above the neckline.   
  
  As I mentioned before, the fact that this pattern was observed by so many made establishing a short a risky trade, as the SPX made only a minimal move toward its target objective before reversing and moving back above the neckline, perhaps sparking short covering. A pullback to the neckline would be interesting, as this would set up another potential bullish inverse head-and-shoulders pattern. My bet is that predisposed cautious traders will fail to recognize and/or act on such a pattern if it materializes, making it a safer pattern to trade because it isn't so crowded.