A Failed Head & Shoulders Pattern

If you are a chart-reading enthusiast like myself, you know doubt are familiar with the head and shoulders pattern that started to form back in May and was completed in early July on all the major indices (minus the NASDAQ which managed only to form a Double-Top). There were undoubtedly thousands of traders watching this pattern complete itself, and confirm the head and shoulders pattern in order that a short position could be taken against (DIA) or (SPY) or maybe even one of the ultras short ETF’s. At that time, my eyes was on (DIA), and I shorted it at 82.20, with a stop-loss at 89.10.

Because there was so many traders getting in on this particular short position, and because so many traders and investors were anticipating it, the indices rejected the idea of a major sell-off and instead, took off on a 15% rally. which along the way, led to us getting stopped out at 89.10. That was our only losing trade that month, but still, there were lessons to be taken from this particular trade.

First, for those who don’t know, a head-and-shoulders patter is atechnical pattern used to identify a top in a particular stock. A stock will typically increase in value followed by a mild sell-off, which is the “left shoulder”. Then the buyers step in to push the index to new highs, followed by a larger sell-off, that sends prices back to about where the previous low was created. At this point the “head” portion of the pattern has been created. Then finally buyers push the price of the stock back up, but instead of creating a new high, it creates a lower high, which becomes the “right shoulder” of the tecnical pattern. Typically these patters take 2 to 3 months to develop or longer. What chart technicians prefer to do is draw a support line underneath the two previous lows, and any break of that support line will be a “sell signal”.

So one major lesson learned from this trade, is when a widely followed index or stock has a chart pattern that is so obvious and so widely spoken of, the chances of that pattern actually coming to fruition, and playing out in textbook fashion, is highly unlikely. So if you see them talking on CNBC about a particular pattern, or there is a number of blogs writing about it, the reality is, that the pattern holds a strong chance of failing, and that is exactly what DIA did to me in the trade below.

The rally we saw, once the neckline was broken (which is where we iniated our trade at), was likely due to short covering and so many people running to cover their positions since the anticipated major sell-off never occurred, and thereby added fuel to the fire, causing the rally to propel itself forward like a freight train.

So you have to be careful about trying to jump on a stock that is showing signs of a large number of traders and investors jumping on board for the same reasons as yourself, because when the technical pattern does actually come about, there will be no more traders to get in on that same position as you are in, and as a result, the stock will reverse course, just like ours did in the DIA trade shown below.

Here’s the DIA Short Trade…