Last week ended poorly for lower-end restaurant stocks. Shares of Chipotle Mexican Grill (NYSE:CMG) fell almost 15% on Friday after a poorly received earnings report. McDonald’s (NYSE:MCD) also tumbled after its earnings release, and the industry’s pain spread to competitor stocks, such as Jack in the Box (NASDAQ:JACK).
Click to Enlarge After returning roughly 55% in 2011, Chipotle Mexican Grill has reversed course this year and to date sits about 30% in the red.
Such is life for a momentum stock.
The good news for traders is that Chipotle stock, while volatile, trades well using technical analysis.
From a pure technical point of view, CMG started carving out a so-called head-and-shoulders pattern during the second half of the summer and into the fall. Friday’s sharp selloff triggered this pattern to move toward its price target as the stock price broke the neckline of the head-and-shoulders pattern.
The way we determine price targets of an H&S pattern is by measuring the distance between the neckline and the top of the head, then subtracting the result from the neckline.
Click to Enlarge In CMG’s case, this simple arithmetic calculates a price target of just around $200 — another 40 points lower from Friday’s close, or roughly 16% lower.
What is important to keep in mind when trading head-and-shoulders patterns — or any “standard” technical patterns, for that matter — is that, like every strategy, it boils down to a game of probabilities.
In other words, some patterns work out and reach their optimal price targets. Some don’t. The key lies in trading all qualified signals/patterns and limiting the losses on the losers.
As it relates to the head-and-shoulders pattern on CMG, I am shorting the stock, targeting the $200 area while using a stop-loss near $285. Alternatively, one could sell far-out-of-the-money calls on the stock, using options with expiration at least three months out.
Serge Berger is the head trader and investment strategist for The Steady Trader. Sign up for his free weekly newsletter.