There Are Trades in Them Thar Hills!

You know you've immersed yourself in trading when you see chart patterns everywhere you look, and in the unlikeliest of places. To me, the ways in which items are arranged on a grocery store shelf sometimes resembles a stock chart. When I drop my kids off at school, and I see them lined up with their peers to go into class, I can't help but notice "support" at their feet and "resistance" at the head of the tallest kid in the line. The panorama of a city skyline from left to right might as well be the chart for a publicly traded company that has rallied, consolidated at the top, and is beginning a sell-off. Even the step counter on my iPhone, with its colored bars of varying heights lets me know if I'm long or short a good health habit.

I wouldn't say I'm obsessed with the markets (then again one who claims to not be obsessed often is). I'd just say I'm usually tuned-in to trading so much so that I tend to relate it to the world around me.

With that having been said, it's no wonder that when I take a drive on I-84 through the Green Mountains of Vermont, for example, or up I-87 along New York's Catskills, I clearly notice stock formations in the mountains and foothills that make up those regions. The type of stock formation that I see most prominently is called a Head and Shoulders.

We've been examining different types of formations that stocks commonly make when putting in a bottom, whether it be a short term bottom or a longer-term one. Thus far, we've examined in some detail historical retracements and double bottoms, which are in many ways simply versions of each other. The head and shoulders formation is also similar to the other two except that instead of being a single retracement to a previous high or low, it has two retracements, giving it three distinct areas in total against which to trade, with the ones on the left and right typically being almost equal to each other and the one in the middle being more pronounced. Think, literally, of a person's head and shoulders, and this will help you to recognize this sort of chart pattern.

Although we've been in the process of understanding and analyzing stocks making bottoms, we know that many of the same formations that help to establish a bottom will also establish a top, just in reverse, as if you flipped the chart upside down. Since the head and shoulders constitutes the top portion of a person's body, we'll initially orient our discussion of the head and shoulders chart patterns around topping action rather than bottoming.

Scale the lower Peaks

Speaking of obsessions, my kids can't get enough of the famous late painter Bob Ross, renowned for his gentle southernly cheerfulness which was a lynchpin of his PBS series The Joy of Painting. On his show he whipped up tranquil oil paintings of nature, seemingly out of nowhere, amazingly all within the course of a 30-minute program. As per the show's direction, my kids each attempt to emulate whatever scene Mr. Ross is painting on a particular show, step-by-step, along with the artist himself. Of course my kids use crayons and colored pencils, not oil paints, which much to their chagrin means that they have to compose their works of art sans both "Tahtanium Hwhite" and "Dark Sienna" among other favorites from Mr. Ross' palate. Invariably my daughter, the youngest of our three, composes a Bob Ross mountain range as three grey humps, with the biggest of the three in the middle. Just like how the ideal double bottom or top makes a perfect W or M shape, the ideal head and shoulders resembles the mountain ranges of my daughter's creation: two identical tops on either side of a taller top in the middle.

Keeping the triple peak visual in mind, we can anticipate a head and shoulders in a similar way to how we can anticipate a double bottom, but with one key difference: With a double bottom, we trade against one point of reference, the bottom directly to the left of the new bottom we're anticipating. With a head and shoulders, we're trading against the left shoulder, or the smaller top to the left of the large top directly to our left.

Pharmaceutical giant Johnson & Johnson (JNJ) created the second, or right shoulder of a head and shoulders formation on January 10th, 2022 and it was straight down from there, as we can see in the intraday chart above. At a price of $173.43, the second shoulder was a near perfect match with the first shoulder at $173.47 from January 5th. For the purpose of catching a directional trade, the second shoulder in a head and shoulders formation serves as conformation that a down move is indeed underway, which we can intuit based on the fact that at least for the time being, the stock didn't have the strength to attempt the higher area. Because of this, it often makes sense to execute a trade only after the right shoulder is fully formed; in other words, at a price slightly below its peak. This will provide a logical stop at a price just above whichever of the two shoulders is slightly higher, so in the case of JNJ above, we would stop ourselves out once JNJ broke through the first (left) shoulder high of $173.47. In most instances, you'll have an opportunity to make a trade close to the peak of the second shoulder, whether it's immediately after it makes the peak price, or a bit later on. Just make sure you pay attention, so you don't squander your opportunity!

If you’re uncertain as to whether you should trade against the left shoulder or the higher high to its right (the “head”), you can look for corresponding areas of resistance to help confirm that the shoulder is a reliable point of entry. Just as support on the downside provides us with an area where an upward reaction can occur, resistance is an upside area where a downside reaction can reasonably take place. Looking at our chart for JNJ, we'll notice some highs and lows, including the last low before the peak of the head, that match up quite seamlessly with our shoulders, thus giving us confidence that the shoulder will hold and lead to a move down.

Bear in mind that trading against the left shoulder means that the head is far enough away that it represents a different trade altogether. In our example above, the head at $174.30 is $0.83 above the shoulder line, so far enough away that one strategy would be to stop out above the shoulder and retrench for a trade against the head. Or, depending on your risk profile and expectations for the trade in general, you can stay in past the head, which is a tactic made less risky the closer in price the head is to that of the shoulders.

Head and Shoulders in Either Direction

A head and shoulders is a natural upside formation from where we can chart an expected downward reaction, but they're equally effective on the downside, and often just as easy to spot.

The intraday chart for 3M (MMM) shows us an upside head of $181.78 on January 5th, 2022, with corresponding shoulders at $181.26 and $181.28 respectively, on the two days immediately before and after. If we then examine the overall range on the chart, we can see another head and shoulders, this time a downside head and shoulders, that however might not have been quite so obvious. The "head" on the downside head and shoulders represents the extreme low for the trading range in focus, which in this case was MMM's January 3rd low of $175.84. The lefthand shoulder of $176.51 was formed during the previous trading session, December 31st, 2021, the last trading day of the year. However, the righthand shoulder didn't materialize until several sessions later, January 11th to be precise, making a low of $176.42 before rallying almost directly up to $179.50 during that same trading session.

If you remember our previous posting we discussed William L. Jiler's analogy that chart formations are often more abstract like a Picasso painting than precise like a Renoir. This is an important distinction to keep in mind because it helps us to recognize a potentially profitable formation even if it doesn't appear to look perfect to us. Both head and shoulders formations that we see in MMM, the upside one and the downside one, are definitely more Picasso than Renoir because they certainly aren't proportioned symmetrically in the ways in which a person's actual head and shoulders are. But, please be mindful that a chart formation of any kind need not be perfect in order for it to be true.

What makes a head and shoulders a bit trickier to nail than a double bottom, for instance, is that you have two points of references of different values to trade against instead of just one. In that case, we can decide whether or not to enter a trade at a price that we assume will form the right shoulder based on two criteria:

1. Where the stock is coming from, that is how big or small of a move it's making to get to our price (this will often take into account the prevailing strength and trend of both the individual stock and/or the overall market).

2. If the right shoulder seems to form up a bit.

Taking the chart above into account, MMM started a definitive move towards the downside of the range after a high of $180.49, the day after its right upside shoulder of $181.28. We can also see in this chart that a move of $3 to $4 usually resulted in a reaction. In this case, coming down $4 from $180.49, a trade around $176.50, which would have matched up with the left downward shoulder, was reasonable. Had MMM trekked lower from a price point below $180.49, we might have been wiser to aim for a price below $176.50, raising the possibility that we would not be dealing with a head and shoulders. If you still weren't confident enough to enter a trade before MMM got down to its price, paying a little bit of attention, you would have noticed nearly an hour's worth of time spent near the $176.50 price, giving us ample time to get in with an easy stop.

The chart to the right details how MMM formed up at around the $176.50 price for almost an hour while putting in the right shoulder, as shown in the chart's 5-minute bars. This included its low of $176.42, giving us an area from which to confidently trade, with an incredibly easy stop to go against in case we were wrong.

The head and shoulders might seem more difficult to trade than other types of formations because it throws a bit more information at us than some others do. So the added data that we need to process, and multiple price points we must consider can lead to uncertainty. That's why we need to pay attention to a chart when we notice a possible head and shoulders. If we understand the breadth of the move the stock is making, meaning that we know the price it's coming from, and if we look for clues that a shoulder is forming up at the desired price, we can comfortably trade a head and shoulders formation with a defined risk that should be quite minimal. When our general area for executing a head and shoulders trade includes additional points of resistance or support, it only strengthens our case for making the trade. While a head and shoulders includes more variables than a double bottom, for example, it pays to be able to recognize them as they will often signal a more definitive reversal, especially within the context of the most immediate range.