Wealth-Making Patterns: Twelfth In A Series
Investors who have held onto a stock that has enjoyed a long run-up will eventually ask themselves: When is it time to sell?
The stock's chart is the first place to look for sell signals.
One pattern that often marks a peak is the head and shoulders. IBD founder and Chairman William O'Neil called it one of the most reliable topping patterns in his book, "How to Make Money in Stocks."
The pattern looks like the outline of a head and shoulders, with the right shoulder typically just below the left. Not only is it a warning to sell, but it also foreshadows a possible short-sale opportunity.
Here's how it works: The left shoulder forms when the stock hits a high and then pulls back, sometimes bouncing off a support level such as the 50-day moving average. It then shoots up to a new high, forming the head: the ultimate peak. Then it drops sharply and wedges slightly upward to form the right shoulder.
Volume often rises as the pattern moves from left to right and selling picks up, and the stock usually becomes more volatile. In a classic head-and-shoulders pattern, the stock breaks down after forming the right shoulder.
Some try to short the stock when it falls below the "neckline" connecting the lows of both shoulders. But that sometimes doesn't work. It's best to wait until the stock rallies to its 50-day or 10-week line two to three times before attempting a short sale.
A head-and-shoulders top can take five to seven months or even longer to form, which is why it's best viewed on a weekly chart.
Deckers Outdoor (NYSE:DECK), the maker of Ugg boots, formed a head-and-shoulders pattern over four months from October through December of 2011 after rising nearly tenfold from its March 2009 low.
The stock ran up to 109.90 in the week of Oct. 14 and then pulled back near the 10-week line to shape the left shoulder 1.
Deckers soon resumed its uptrend, hitting a record high of 118.90. It retreated to just below its 10-week average over the next month. This formed the head 2.
The stock then poked back above its support line before breaking below it, forming the right shoulder 3.
In the week ended Feb. 24, it tried to retake its 10-week moving average, only to fall from the line in heavy volume 4. That triggered a short-sale point, although at that time the stock had made just one attempt to regain the 10-week line.
Note that only experienced chart readers should attempt a short sale. Also, short sales generally shouldn't be attempted while the market is in a confirmed uptrend.