Walter Energy, Inc. (NYSE: WLT)

A Head and Shoulders (H&S) pattern is a reversal pattern that forms after an uptrend. A textbook H&S pattern starts to form when a stock rallies to a point and then pulls back to a particular level (left shoulder). Next, the stock will rally again, but this time to a higher peak (head) than the previous one. After forming the head, the stock will pull back to the same support that the first shoulder did. Finally, the stock rallies a 3rd time, but not as high as the head (right shoulder). The level that has been created by all 3 of the pullbacks is simply a support level referred to as the "neckline". The formation of an H&S pattern warns of a potential reversal of the uptrend into a possible downtrend.

H&S patterns can also form upside-down after a downtrend as well. This pattern would be called an Inverse Head and Shoulders pattern. It too would be considered a reversal pattern and the neckline would be a resistance rather than a support.

To see such a pattern potentially being formed, please take a look at the 1-year chart of WLT (Walter Energy, Inc.) below with my added notations:




After moving lower for the entire year, WLT has almost formed what appears to be an Inverse H&S (blue). I have noted the head (H) and the shoulders (s) to make the pattern more visible. (For future reference, if you imagine this pattern flipped upside down you would have a regular H&S pattern.) WLT's "neckline" is at the $40 level (red). WLT would confirm the pattern by breaking up through the $40 resistance, and if it does, the stock should be moving higher from there.

Keep in mind that simple is usually better. Had I never pointed out this Inverse H&S pattern, one would still think this stock is moving higher simply if it broke through the $40 resistance level. In short, whether you noticed the pattern or not, the trade would still be the same: On the break above the key $40 level.