A head and shoulders pattern shows the transition from uptrend into a potential downtrend. While no one pattern works all the time, when a head and shoulder pattern completes it signals that the price of the stock could continue to move lower. This alerts those that are in the stock that it may be time to consider selling, and may entice others to look for short trade opportunities.
Consolidated Edison, Inc. (ED) has been in an uptrend extending back to mid-2015, reaching a high of $81.88 in July. The patterns are formed by the left shoulder on April 1 at $77.23, followed by the July $81.88 "head," then the right shoulder at $79.54 on Sept. 27. The pattern completed when the price fell below the neckline of the pattern near $73.50. The neckline is the trendline that connects the swing lows following the left shoulder and head. Between the $81.88 high and the swing low at $72.93 following the head, the height of the pattern is $8.95. Subtracted from the neckline, that gives an estimated downside target of $64.55. A smaller head and shoulders pattern formed between February and May. Ultimately, the price moved higher after that pattern, and not lower. Small head and shoulders patterns can act as continuation patterns and not reversal patterns. Since this current pattern is bigger than the last one, it is a better signal of lower prices to come. A rally above $79.54 would indicate otherwise.
Grupo Financiero Santander Mexico (BSMX) has been in a long-term downtrend but rallied between February and June. In June it hit a high of $9.62 (left shoulder), followed by a correction to $8.06. The stock then rallied to $10.13 (head) followed by a correction to $8.25. The stock could now be forming the right shoulder of the pattern, but the patterns aren't complete until the price drops below the neckline near $8.30. If that occurs, the price is likely to continue its long-term decline, with a downside target of $6.42. That target is just slightly below the $6.76 low recorded in February. A rally above the Oct.10 intraday high of $9.26 indicates the right shoulder could still be forming, as long as it stays below $10.13 and then drops below the neckline. If the price rallies above $10.13 from here, the pattern never completed and the uptrend that began in February is still underway.
Flowserve Corp. (FLS) has been forming a complex head and shoulders pattern since March. This pattern follows a rally at the start of the year. The head and shoulders pattern completed on Oct. 13 when the price dropped below the neckline at $44.50. Some traders may also view a drop below the June swing low of $42.85 as a selling point. Based on the completion of the pattern the downside target is $35.50. A rally above $49.66, the right shoulder high, indicates the pattern has failed, and the uptrend that started at the beginning of the year may be continuing.
The Bottom Line
Many traders watch the head and shoulders reversal pattern. It can signal the end of an uptrend, and that a downtrend is emerging. No pattern is perfect, though. If the pattern completes and then moves above the right shoulder, that is usually a signal the pattern has failed. The height of the pattern can be subtracted from the breakout price (neckline) to give an approximate downside price target. This is just an estimate. The price may not drop that far, or it may drop further. Such estimates do allow traders to make risk/reward assessments, though since the target is based on recent volatility and price moves.
Disclosure: The author has no position in the stocks mentioned.