#251 - The Basics Of A Head And Shoulders Pattern

Episode of: The "Daily Call" From Option Alpha

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May 31, 20186m
#251 - The Basics Of A Head And Shoulders Pattern
May 31 '186m
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Hey everyone. This is Kirk here again from optionalpha.com and welcome back to the daily call. Today, we’re going to be talking about the basics of a head and shoulders chart pattern. Some of you might be wondering why, Kirk, on earth are we talking about chart patterns on a podcast that's focused on options trading. It’s because I think when it comes to chart patterns, the head and shoulders pattern is probably a little bit, slightly more reliable than some of the other patterns out there and obviously, easier to spot. It's not as subjective, necessarily as some of the other patterns. My biggest rub or push with many chart patterns and using lines on charts, etcetera is that it’s very much subjective, meaning that you can give a chart to say 10 different people and I could tell them, draw support and resistance, draw trend lines, draw channels and you could potentially get 10 completely different things. Head and shoulders patterns in most cases are pretty easy to find and spot once they've mainly completed or once they’re about to be completed because they very much create that head and shoulders framework on the chart. I want to go through this today just to help you out a little bit if you're new to chart trading or chart reading. I don't use this often. Like I said, most of the stuff that I do is options probabilities, but when we are looking at charts, these ones usually tend to stick out a little bit more.

Head and shoulders basically create what they sound like. It creates a lower left shoulder, a high peak in the middle of the chart pattern which is the head and then a lower right shoulder. If you look at say a human, you have this lower left shoulder, higher head and then lower right shoulder. And so, when you see these starting to form, you have a run-up in the market and then the market has a retracement and that's really this left shoulder, no difference here and everything seems to be okay. That's how the pattern forms, just a regular, natural say move up in the market. This can all happen in reverse, but we’ll just assume an uptrend for right now. And then the stock starts running up or the market starts running up and it goes higher than the most recent high and then runs up again and again, pulls back. But this time when it pulls back, after it’s had this huge peak in the middle, it pulls back almost to where it fell the last time. It pulls back more than say normal, “than a normal pullback.” And so, this is what generally forms what’s called the neckline. What you would want to see in most head and shoulders patterns is a neckline that is very level and flat, meaning that the stock had a run-up, a pullback to the neckline and then a huge run-up in the middle to form the head and an even bigger pullback to a neckline. This is showing a little bit more weakness. The stock is trying to have this huge move higher, but then it’s very, very weak and then it ends up pulling all the way back to the previous low. And then on the right side of the shoulder now, this third peak that starts to form should always be lower than the middle head. Now, we start to see the stock maybe make a run higher, but it never quite gets to the recent high. This is where we start to see the weakness really start to unfold. The stock is trying multiple attempts at regaining the trend or regaining the momentum, but just fails. And so, at this point now, the right shoulder gets created and again, it's best to see the right shoulder much lower than the middle head. The stock maybe on the move up in the head and the middle ran from 50 to 55. Well, on the right shoulder, you’d want to see the stock make a move from 50 to say 52. It fell short and it starts to turn all the way back over. But this pattern is only complete though and I think this is what people really mess up with this, is they start to see these unfold and then they try to jump in front of them which is again, is really subjective anyway, but it's only really complete once the stock actually breaks the recent lows.

This whole idea of higher highs and lower lows really comes into play with head and shoulders patterns and many chart patterns. This thing only really suggest that the trend is now completely turned over and reversed when we start to see the stock break through that neckline and so, basically take out the most recent lows. That to me shows complete failure, that the market has completely turned around or completely failed on the top side. The stock has tried to make multiple attempts, it gets weaker and weaker and then basically, it just breaks down. Again, for me as an options trader, this is not something that I look at all the time. I’m not out there scouring the market for head and shoulders patterns, but it's probably one of the more easier ones to notice when we get into major trend changes because it tends to be so well-defined. It tends to be this rounding top or rolling top that we see where you just can naturally see on the chart that the stock is trying to make these moves higher and just continues to fail. For me, it doesn't necessarily change things, but if I see something starting to develop, I start to see that the stock is now failing to regain the highs, that might change my dynamic a little bit. Maybe I go a little bit more bearish or maybe I check technicals at that point and see if there are any technical signals that might suggest that this is maybe a short-term top and we could go bearish or we could potentially go bullish if it's an inverse head and shoulders pattern. Hopefully this helps out. Again, I just want to get the basics out there because I feel like this is like I said, maybe a little bit better one to use if you're going to use subjective chart reading and chart patterns. I’m not a fan of many other things, but head and shoulders patterns tend to be okay because you can see them happening in the market. Hopefully this helps out. As always, if you guys have any questions, let us know. Until next time, happy trading.

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