Today I thought I’d cover two stock charting patters that everyone should know. These are the Head and Shoulders Pattern — a bearish signal — and the Cup and Handle Pattern — a bullish signal. For both of these I’ll use the chart of Harley Davidson for the last two years:
As I’ve said in the past, I don’t let charting influence which stocks I buy or sell. I don’t simply look for stocks that are showing a certain pattern and buy or sell based on those patterns as some do. In general I find that charts are more useful for determining where you are rather than where you are going. The pattern can always change – an up-trend can become a down-trend and then the down-trend can become an up-trend again. Probably the most important thing about charting is that others are doing it and it influences their behavior to some extent. There is also some economic basis behind head and shoulders and cup and handle, so they are good patterns to know.
First, the head and shoulders pattern. A head and shoulders (HAS) pattern is a bearish pattern that signals that a stock has peaked after a run up. One should then expect the stock to begin to fall in price. For a HAS pattern to develop, a stock must be in an up-trend (new lows are getting higher and new highs are getting higher), reach some maximum value (the head), and then fall and fail to reach the old high during the next upward movement (the right shoulder). Note that the peak and fall before the head was formed was the left shoulder. For Harley, a HAS pattern occurred between March and Mid May. The left shoulder occurred during March, the head occurred during April, and then the right shoulder occurred during early May when the stock failed to reach the April high. Note that the pattern was not complete until early June when the price finally fell below the low set in early May (the Flash Crash).
Note also that by the time the pattern was complete, the stock had already dropped from over $35 to under $28, so 20% of the value had already been wiped out. In general this is the trouble with charting – yes, we’ve reached a peak and are now on a down-trend, but by the time the chart shows this a lot of the movement has already happened! Probably the more important aspect is that many stocks are now showing a HAS pattern, suggesting that the whole market is acting together rather than just certain stocks. This means that good and bad stocks are falling, which will lead to buying opportunities.
A Cup and Handle (CAH) pattern is a bullish trend that occurs after a stock has dropped. For Harley, there is one between May 2009 the early July (the cup rim ) and July 2009 and the middle of August (the handle).
During the cup phase investors are waiting to see if the stock has finally bottomed out, and therefore the price tends to be fairly flat. During the handle formation, the stock price finally moves up enough to convince investors that it is time to enter again as the price breaks out of the range formed during the cup phase. When the stock falls back at the end of the handle but stays above the level of the cup, the stock is now in an up-trend, so people start to buy.
Note again though that the stock has gone from $15 to $22 before the handle is defined so a 50% gain was missed!
In summary, charting is nice if you want to see if a stock is moving up or down generally, and some patterns are useful in spotting buy or sell points if you are looking to get into or out of a stock anyway. Trying to trade just based on patterns will generally lose you money though because you’ll be buying too late, selling to late, and generally trading a lot more than you should. You’ll end up selling just before a big move up because you see a HAS or watching a stock gain 50% before you buy waiting for a handle to form, only to then watch the stock form a HAS pattern and crash.
So pay attention, but not too much.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.