Last week we discussed the powerful head and shoulders chart pattern along with a few recent examples. This bearish pattern is a sign of impending breakdown following an extended run-up in price. The formation is relatively rare and one that is much coveted by traders since it has a high probability of working. Even more rare is finding its opposite, but I believe I found one today. It’s pretty easy to spot this pattern after it’s already happened and what excites about this chart is that it’s still in process of setting up. This will give us time to see if it completes the formation and to profit from it if it does.
What is my discovery? It’s a chart of Sovereign Bancorp (SOV) which I found while persuing stocks in the beaten up financial sector.
An inverse head and shoulders formation is a bullish pattern which occurs after a steep decline in price. A steep decline is crucial to the setup and clearly we’ve got that. The left shoulder was formed on Nov. 27th on volume of about 10.6 million shares, the head formed on January 22nd on 9.7 million shares, and the right shoulder was recently formed on March 7th on volume of 6.2 million. Each successive formation must occur on decreasing volume, and that’s the case here. So far, so good.
As you can see, the formation is fairly symmetrical. The shoulder peaks occur right at the $10 level. The neckline is the line drawn between the shoulder crests, around $13.30. Today the stock is bouncing off its $10 shoulder support. If you’re short the stock, now would be a good time to cover.
So, when should we look to jump in with our long positions? Assuming the pattern doesn’t breakdown, we’ll look to go long just after the stock rises back to the neckline level and breaks through it. I’m estimating this will occur sometime near the end of this month or the beginning of the next. If it does, our entry point will be just above $13.30 with a price target in the $17-$18 range. (The target price is the neckline price (13.30) plus the difference between the top of the head and the neckline (about 4.6).) A weekly chart of SOV shows that it has a major resistance level near $17.25, so it needs to clear that first before it can head higher.
If this pattern plays out and you buy the stock just above the neckline, you can expect at least a $4 gain which translates into a 30% return on your investment. Fortunately for all you options players, SOV offers a liquid options playing field meaning there’s a lot of open interest in near the money strikes. Buying call options increases your leverage thus magnifying your return. Okay, so what options should you buy? Since it might take a month or so for the stock to reach its price target, buying the July 12.5 or 15 call options will offer the best bang for your buck. If you’re feeling extra bullish, you can also sell a bull-put credit spread (say the April or May 15/12.5) to offset the price of the calls.
Add this stock to your watchlist, set an alert for 13.30, and let’s see how this puppy plays out!
Update on Yesterday’s Heavy Metal Stocks:
JOYG broke its $70 resistance level today. Yesterday I got an email from my girlfriend who’s a VP at the company and she says business is going gangbusters and they’re in the middle of a hiring frenzy. Thought you’d like the heads-up.