Head and Shoulder Patterns Near Breakout Levels

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The Head and Shoulders pattern (H&S) is a classic topping pattern, where the stock makes two successive new highs, but then fails to make a new high on the third attempt. This often indicates that the stock is headed for a decline, but only if the pattern actually "breaks." These four stocks are near H&S breaking points, which is the entry for the trade. Since the H&S is a topping pattern these are all potential short trades, but with major indexes at all times highs, including the SPDRs S&P 500 (ARCA:SPY), taking on short positions does warrant some caution.

PulteGroup (NYSE:PHM) broke below its H&S pattern on July 25 when the stock gapped lower. A price objective is obtained by taking the height of the pattern and subtracting it from it from the breakout price. With the breakout occurring very near $18, and a pattern height of $6 (rounded down), the price target for the decline is $12. I'd place a stop loss near $20.75, which is just above the latter high of the right shoulder. An alternative entry is to wait and see if the price rallies to test the breakout point near $18, and then enter a short in that vicinity. This option provide a better risk/reward, but if the stock doesn't test the breakout point then the trade is missed.

Autodesk (Nasdaq:ADSK) actually broke out of its H&S pattern back in May, but the rally in July has brought the price back back above the breakout. This "second chance" trade is fairly common with H&S patterns, and one benefit is that the risk is slightly less because the price is above the breakout point (and original entry price). Before entering short though I'd like to see the stock drop below minor support at $35.95. If that occurs the price target is $31. There are multiple stop levels I believe are good choices, although $38.50 is the one I prefer.



Taiwan Semiconductor (NYSE:TSM) is in a similar to position to Autodesk, in that it broke out earlier, but has rallied back to near the breakout point. If the price drops back below $16.68 I like the short trade, with a target of $13.50. Placing a stop at $19 is ideal, but just above $18.30 is likely also fine as it is just above a gap which occurred during the right shoulder.



Martin Marietta Material (NYSE:MLM) broke below the H&S breakout point on July 30, and closed nearly right on it after a wide-ranging sell-off day. Before taking a short position I think the prudent choice is to wait for the price to drop below the July 30 low at $95.64; this will provide some confirm that there is still selling pressure. The orginal breakout/entry price is just below $98, and is still valid. though. The target for the downside move is $79 with a stop-loss just above $107.



The Bottom Line
The head and shoulders pattern is a classic topping pattern, often indicating that the price will continue to slide once the pattern completes. Of course that doesn't mean the stock will always drop. That's why a stop loss order is used to control risk. The profit target is an estimate of where momentum could take the price, it is not meant to pinpoint an exact low or reversal point. Also, since H&S patterns can take months to form, reaching the profit target may also take as long.

At the time of writing, Cory Mitchell did not own shares in any of the funds mentioned in this article.

Charts courtesy of StockCharts.com.