The head and shoulders pattern is one of the most followed patterns by technical traders.The left shoulder and head show that an uptrend was formerly in place, the lower right shoulder (relative to the head) shows a short-term downtrend has developed. A "breakout" of the pattern is created when the price drops below a trendline that connects the low of the left shoulder with the low of the right shoulder. This trendline is commonly called the neckline.

head and shoulders graf

While the pattern shows the stock has already been trending lower for some time, a break below the pattern (neckline break) signals there is more downside to come. Active traders usually use this opportunity to watch for short position entries. The pattern also lets longer-term traders know that a stronger lower trend may be coming. Some traders could potentially consider the following stocks as prospects for applying strategies around head and shoulders patterns. (For more on active trading, click here)

In 2014, Zions Bancorpartion (ZION) made a high of $32.29 in January (left shoulder), retraced, made a high at $33.33 (head) in March and has made a series of lower highs since. Due to the stock's choppy price action over the last year, the neckline could be drawn in a number of different ways. A drop below $27.60 would take out all support going back to November and potentially indicate a drop back toward the $23.50 region. Over the last year, though, the price has repeatedly bounced off levels above $26.39, so even a drop below $27.60 doesn't strongly signal a further decline. Bulls may want to watch for a move down into the $26.50 to $27.50 area followed by another rally. This move will catch some bears by surprise, likely pushing the price back to $30+.

zions stock chart

CBS Corporation (CBS) has a more clear-cut head and shoulders pattern. A strong uptrend peaked in March at $68.10, and then retraced to $55.01 in May. A subsequent rally (right shoulder) pushed the price back up to $65.24, but a strong retreat from that level indicates the short-term downtrend is continuing. Whether the price breaks below the prior low at $55.01 will help establish if a long-term downtrend is underway, potentially pushing the stock toward the $44 to $42 area. This target is attained by subtracting the approximate $13 height of the pattern ($68 high minus $55 low) from the breakout point of $55. This gives a target of $55 - $13 = $42.

If the price stays above $55.01 or moves above $65.24, the bulls most likely will maintain the upper hand; those who are bearish are recommended to be cautious in fighting against the long-term uptrend.

cbs stockchart

USG Corporation (USG) already broke below its head and shoulder neckline. Following a breakout, the price will often retrace to near the breakout point, providing short sellers a second opportunity to get in, and those who are still long a chance to get out. The original breakout point was $28.56 (just below the May low) so any move into this area is an opportunity to exit longs or initiate short positions for those who believe the stock will continue lower. If a full downtrend does develop, the target based on the pattern is near $22. On the other hand, a strong rally back above the breakout point, and above the June high at $32.21, would nullify that target and the current bearishness.

usg stockchart

Chicago Bridge & Iron Company (CBI) also broke below its head and shoulders, and near reached the $63 price target for that pattern. The very sharp drop in June though signals that the overall downtrend may not be over. A pullback between $79 and $76 would put the price right near the neckline breakout of the original head and shoulders pattern, and provide a short entry point with the expectation that the price will continue below the June low at $64.67. In the short-term, a drop below the $66.50 will break the trendline of a small consolidation indicating more downside could materialize before a bounce.

cbi stockchart

The Bottom Line

Head and shoulders are popular chart patterns, but they don't always work out, nor are the price targets associated with them always reached. The pattern shows a transition from an uptrend to a downtrend. When the pattern breaks, it indicates that a downtrend could continue. This doesn't always occur immediately, as some of the selling pressure has already been eased by the short-term downtrend already in place. While head and shoulders can be effective patterns for trading, there are always multiple factors acting on a stock beyond a single pattern. Before each trade, define your entry point and risk (via a stop loss) and then stick to it. Have a clear strategy and only risk a small percentage of your trading account on each trade, so even if you are wrong on a number of trades, it won't significantly draw down all your capital.

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