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Cramer: Yikes! The scariest pattern in the chart book

The most simple and reliable chart pattern out there is one that Jim Cramer dreads.

Unfortunately, Cramer learned not to ignore the head-and-shoulders pattern the hard way when his charitable trust bought Alcoa in the low teens in 2010, and ultimately took a loss because it was a really early buy.

"Yes, just like a human's head. That is the most frightening pattern in the chart book," the "Mad Money" host said.

Alcoa's stock had a healthy run from winter of 2010 until February 2011, rising to $17 from $13. The stock ran to $18 on the eve of its quarterly earnings report, and Cramer thought it was a fine quarter when it reported.

Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange.
"Yes, just like a human's head. That is the most frightening pattern in the chart book." -Jim Cramer

Yet, what worried him was that even after an initial positive reaction, the stock dropped. So, a few days later, Cramer assumed it would take out its $18 level and went back to buy more.

Cramer was wrong — extremely wrong.

What Cramer didn't realize is that the fluctuation in price had traced a perfect head-and-shoulders pattern. And no, this isn't referring to the brand of a shampoo.

It turns out that during that period when the head-and-shoulders pattern was forming on Alcoa's chart, Europe and China began to slow down, and aluminum was in a glut. Ultimately, CEO Klaus Kleinfeld could control his own company but not the price of the commodity itself.

Likewise, if a head-and-shoulders pattern signals trouble ahead, then an inverse head-and-shoulders pattern signals the opposite — a chance for glory.

"The key with this pattern is the neckline, the line that connects the high to the two shoulders. When a stock breaks out above that line it tells a technician that you are about to witness a big move higher," Cramer said.

At the end of the day, patterns matter. So when you see a head-and-shoulders pattern, no matter how confident in the stock you might be, Cramer believes you should sell. And when the reverse head-and-shoulders develops, then consider buying it.

That is just how powerful these moves are. The chart work is more often right than most would ever think possible.

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