Chart Smarts: How to Trade a Head-and-Shoulders for 51% Gains
If you’ve been following the markets for a while, chances are you’ve heard of the “head-and-shoulders pattern”. I’d venture to say that it’s probably the most well-known chart pattern in the world of technical trading. But just being able to spot this formation on a chart doesn’t necessarily mean that you’ll book gains – that’s because there’s a big disconnect where the rubber meets the road.
Today, we’re going to fill that void by looking at head-and-shoulders trading tactics through the lens of a real-world trade that gave my Penny Momentum Trader readers a chance to book 51% gains in just five days. Here’s everything you need to know to do the same…
It’s important not to get too caught up with patterns. Ultimately, patterns are just an easy way to describe significant technical price action in stocks – they’re not an end unto themselves. That’s evident in the fact that an estimated 90% of traders lose money. But by applying trading rules to patterns, that number can shrink significantly.
Simply put, a head-and-shoulders pattern is a bearish formation that’s made up of three “peaks” in a stock’s price action – one large peak (the head), and two smaller peaks on either side (the shoulders). It signals a top in a stock. Remember, though, it’s not the pattern that’s important, it’s what the pattern represents: a head-and-shoulders is a good indication of exhaustion in a stock’s share price – as trading volume declines in the head, and prices fail to reach previous highs in the right shoulder, the market’s giving serious indications that bullish powers are waning.
Statistically, the head-and-shoulders pattern is worth watching. An academic study conducted by the Federal Reserve Board of New York suggests that the results of 10,000 computer simulated head-and-shoulders trades resulted in “profits [that] would have been both statistically and economically significant.”
Like I said before, though, the toughest part of successfully trading a head-and-shoulders pattern isn’t in identifying it in a stock chart; instead, it’s the challenge of picking the right entry and exit points.
For a real world example, let’s take a look at Endeavour Silver Corp. (AMEX: EXK), a small-cap silver company that I recommended to my Penny Momentum Trader readers back on March 2. Shares of EXK had been forming an attractive inverted head-and-shoulders pattern, an upside down head-and-shoulders that’s a bullish setup.
Take a look at the chart below for a visual description of this stock’s price action:
The “buy” trigger for EXK came on the first day that broke the stock’s “neckline” (also sometimes called shoulder level), the line that connects the small peaks on either side of the shoulders. It’s not enough that shares broke above the neckline, however – what traders should be looking for is a confirmed breakout. That means conclusive evidence that the push higher is more than just a minor intraday whipsaw.
Good confirmation includes a close above the neckline, followed by an open above it the next day. More conservative traders would be wise to wait for two consecutive opens above the neckline, just keep in mind that your extra margin of safety comes at a cost of lost potential gains.
The key to a successful exit on the trade comes from setting a realistic target price. In a head-and-shoulders pattern, the general rule for determining a target price comes from measuring the distance from the peak (or trough) of the head to the neckline. Then, measure that same distance on the other side of the neckline – that’s your price target.
For us, we opted to close out the trade on the first trading day that breached our target price (the dotted red line in the chart above). By doing that, we actually managed to capture near-maximum gains – as you can see from the chart, prices reversed just days after we sold.
Ultimately, readers who bought the option I recommended were able to cash out 51% gains in just 5 trading days.
By setting your trigger buy price (at the neckline) and your target price ahead of time, you’ll be able to take emotion out of your trades, define your potential gains ahead of time, and statistically improve the percentage of winning trades in your portfolio.
Obviously, there can be a steep learning curve to technical trading – but with practice, it can become as comfortable to you as any other investment method. When just getting started, I’d always recommend using paper trading before you sink real cash behind any new strategy.
March 18, 2011
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