The head-and-shoulders bottom is a popular pattern with investors, which marks a reversal of a downward trend.
I have three stocks for you that are forming a head-and-shoulders bottoms:
1. Honeywell (HON)
2. Cliffs Natural Resources (CLF)
3. U.S. Steel (X)
And I’ll tell you exactly how you should trade them.
As investors, we are looking for increasing volumes at the point of breakout. This increased volume definitively marks the end of the pattern and the reversal of a downward trend in the price of a stock.
And even though we aren’t to the neckline and ready for a breakout yet in CLF, X and HON, we should get prepared for one with call options.
A perfect example of the head-and-shoulders bottom has three sharp low points created by three successive reactions in the price of the financial instrument. It is essential that this pattern form following a major downtrend in the financial instrument’s price.
The neckline is formed by drawing a line connecting the two high price points of the formation. The first high point occurs at the end of the left shoulder and beginning of the downtrend to the head. The second marks the end of the head and the beginning of the downturn to the right shoulder. The neckline usually points down in a head-and-shoulders bottom, but on rare occasions can slope up.
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The pattern is complete when the resistance marked by the neckline is “broken.”
This occurs when the price of the stock, rising from the low point of the right shoulder moves up through the neckline. Many technical analysts only consider the neckline “broken” if the stock closes above the neckline.
Until the neckline breaks, it will serve as resistance and we can trade it accordingly. We buy just slightly out-of-the-money options at support and sell them when we hit the neckline.
When the neckline finally breaks and we close above it, we no longer have to sell and flip out of the trade. At that time, we will be able to just ride the stock up to its target.
Because HON, CLF and X remain below the neckline, here are the trades.
Honeywell (HON)
Buy the HON Dec 34 Calls (HONLM) when the stock pulls back to the $33 area.
Take profits when the stock hits the $36-37 area. When the stock closes above that level check back for the next trade.
TRADE UPDATE: Our HON options are now on a new all-time high, rising from $1.08 to more than $4. It’s time to book the profits with the stock hitting my target area.
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Cliffs Natural Resources (CLF)
Buy the CLF Oct 27 Calls (CLFJI) when the stock pulls back to the $25 area.
Take profits when the stock hits the $30 area. (This will be our second profitable trade with CLF.) When the stock closes above that level check back for the next trade.
TRADE UPDATE: Our CLF options have risen from $1.10 to more than $4. Even though the stock is about 50 cents from my target, I suggest closing this position.
U.S. Steel (X)
Buy the X Oct 40 Calls (FBJJH) when the stock dips to the $36 level for a ride back above the $40 level.
Take profits when the stock hits the $42 area. (This will be our second profitable trade with X.) When the stock closes above that level check back for the next trade.
TRADE UPDATE: This was the monster trade out of these three. It hit a new contract high of $9.19 on Aug. 13, after rising from just 85 cents. With the stock gapping above my exit area, if you haven’t locked in profits then I can think of no better time.
The old ways of investing don’t work anymore. But trading options founded on scientific principle can and does work in volatile times like these.
In his latest report, learn how John Lansing leverages the power of technical analysis to identify the short window when a trade is set to go straight up or down. Get your FREE copy here!
