Ideas for Trading a Head-and-Shoulders Pattern

07/05/2010 12:01 am EST


Brandon Wendell

Senior Instructor, Online Trading Academy

Several weeks ago, I wrote about a possible head-and-shoulders reversal pattern that was forming on the S&P 500 index. Today I was asked by a student, "How should we trade this pattern?" Most of you have read a trading or investing book in the past that describes the pattern and the entry point that is typical for the trend reversal. The problem is, if the authors of these books were right and everyone who followed them made money, where are all of the millionaire or billionaire traders/bookworms?

To be successful in trading, we should be focused on trading based on supply and demand levels and just use patterns as an odds enhancer for our trades that are already identified from our analysis. In the XLT, students are also aware that we need to find what the novice traders do and take the opposite position, just like the professionals do.

Let's look at the head-and-shoulders pattern and see where the professionals would have entered and what you may be able to do now. The first picture shows the similarities between the current and previous head-and-shoulder reversal pattern. Timing plays a large part in the markets, and if you were to look at the inverted head-and-shoulders patterns from 2002 and 2009, you would see that they too share timing of 22 weeks between both shoulders.

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As you can see from the picture above, the head was formed at a resistance level. There was also a diamond pattern that increased the odds for success in shorting that touch of resistance. Looking at the current head-and-shoulders pattern, the conventional wisdom says to short on a break of the neckline after the right shoulder and place your stop above the right shoulder. Why not enter a short on the right shoulder if you are at resistance and therefore reduce your risk (distance between entry and stop)?

So were there resistance levels and a trade signal at the top of the right shoulder? Well, not the traditional ones that would have made for a great entry. However, the trend traders were able to enter a position. The exponential moving average that I use as a long-term trend identifier held as a resistance level. The bearishness was confirmed with negative divergence and a bearish engulfing pattern on the chart.

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For those requiring more confirmation, the break of the lows of the engulfing pattern would have signaled an entry with the stop placed above the swing high of the June 21 candle. The target of the June 7 close would offer a nice risk/reward ratio as well. So while there was not a great entry on the weekly chart, traders on the daily were able to take advantage of the larger trend reversal pattern and profit, while many traders are still waiting for their entry.

Speaking of that entry, most people will trade short on a break of the neckline. Professional, consistently profitable traders do not trade with most people. Watch the break as it will be telling and waiting for a pullback, or retest, of the neckline as resistance will most likely offer you a better trading opportunity with greater potential for working out. Look at the failed complex head-and-shoulders pattern from early summer 2009. This pattern was talked about non-stop on CNBC. As you can see from the picture, professionals made money on the trade from the top of the right shoulder. Patient traders who watched the breakdown and waited for a retest avoided the losses that most novice traders endured by shorting in the "book" entry.

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You may ask, "But Brandon, what if the retest never comes? I'll miss the trade?" Well, so be it. I'd rather miss some great trades than be in on every bad one. Trust me, your money will last longer that way. Look at the major top from 2007.

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Only time will tell what will happen with the markets. But this pattern had appeared well before all of the negative news on housing that is currently being released. We also have earnings season next month as the second quarter draws to a close. Trade what the market is telling you and trade safe!

By Brandon Wendell, trader and instructor, Online Trading Academy
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