Head And Shoulders Pattern Signals A Move Lower

By Cory Mitchell | Updated September 02, 2014 AAA

These four stocks are very close to completing head and shoulder patterns. A head and shoulders is a topping pattern, which indicates the uptrend is likely already in reversal mode and about to head even lower. When these pattern complete (break the bottom of the pattern) bulls should tread carefully and bears can seize shorting opportunities.

Capital One Financial (NYSE:COF) was moving aggressively higher to end off 2013, but has fallen well of the high in 2014. The price made similar lows near $68 over the last several months, and if that level is broken the head and shoulders pattern will complete. A drop below $67.80 signals the short entry. The stop is placed near $73.50, which is just above the right shoulder (currently). The total height of the pattern is approximately $10; this is subtracted from the breakout price to provide a target of $78 (rounded).

Newfield Exploration (NYSE:NFX) has been in a multi-year downtrend, but in late 2013 staged a rally that could have turned things around. Instead, the stock has given back nearly all the gains and is in danger of breaking lower. $22.70 is where the price bottomed in August and December, so if that level is breached it will complete the head and shoulders pattern. Sell on a move below $22.70, with a stop near $27 which is above the right shoulder (currently). This is a large pattern and indicates an approximate target of $14. That target may be too ambitious though; the price has been predominantly in a big range since mid-2012, so a shorter-term target near the low of $19.50 is likely a better spot to take some profit. If the price breaks lower then the $14 target becomes more reasonable. Aggressive traders can enter a short position earlier if the price breaks below the recent swing low at $23.50.

With Darling International (NYSE:DAR) the head and shoulders pattern is more complex, and could be viewed different ways by different traders. If this pattern was noticed in December traders would have already gone short as the price dropped below the pullback lows ("armpits") near $20. That ended up being a false breakout, although if those traders had placed stops above the right shoulder they are still short. The price created a second slightly lower right shoulder, and the moved lower to find support at $19. Entering short near $20 is one possibility, while waiting for a break below $19 is another. In either case the stop is just above the second right shoulder--approximately $21.75. Target is $16 to $15. With one false break to the downside already this pattern isn't clear cut, although overall the price is making lower highs indicating the price is under downward pressure.

Whole Foods Market (Nasdaq:WFM) is also a larger and subjective head and shoulders pattern. In December it appeared a head and shoulders was complete when the price broke below $56 (diagonal line) after an initial right shoulder. Before reaching the target the price bounced again, creating a second right shoulder. If the price breaks back below $50 selling is likely to resume. A stop can be placed above $56.50, and the overall downside target is $35. The price has been making lower highs since November indicating the trend is currently down, but $50 has also held as support on multiple occasions.

The Bottom Line

The right hand side of the head and shoulders pattern is the real story. It shows the price couldn't make a new high, and instead created a lower high and a lower low. Prices can move in complex ways though, therefore, the pattern doesn't always indicate a reversal. Two of the stocks show the head and shoulders drawn in different ways, so there is often more than one way to trade the pattern and it can be subjective. Risk is capped with a stop loss, and trades are only taken if the profit potential exceeds the risk by at least 1.5 to 1.0. For example, if the risking $1 per share, the profit target should produce a profit of greater than $1.50 per share.

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.

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