As the head and shoulders top, the head and shoulders bottom is a popular pattern with investors. The reverse of the head and shoulders top, the bottom marks a reversal in a downward trend in a stock’s price. This pattern most commonly occurs during the reversal of a major trend, a trend that has been in existence for a year or more.
The Head and Shoulders Bottom sometimes referred to as an Inverse Head and Shoulders, is a pattern that shares many common characteristics with its comparable partner, but relies more heavily on volume patterns for confirmation.
As a major reversal pattern, the Head and Shoulders Bottom forms after a downtrend, and its completion marks a change in trend. The pattern contains three successive troughs with the middle trough (head) being the deepest and the two outside troughs (shoulders) being shallower. Ideally, the two shoulders would be equal in height and width. The reaction highs in the middle of the pattern can be connected to form resistance or a neckline.
The left shoulder happens as the price of the stock in a falling market hits a new low and then rises in a minor recovery.
The head appears when prices fall from the high of the left shoulder to an even lower level and then rise again.
The right shoulder happens when prices fall again but don’t hit the low of the head.
Prices then rise again when they have hit the low of the right shoulder.
The neckline is a key component of this pattern. The neckline is formed by tracing a line connecting two high price points of the formation, as you already know.
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.
Many technical analysts only consider the neckline “broken” if the stock closes above the neckline.
It is crucial for an investor to monitor the volume pattern to determine if what looks like a forming head and shoulders bottom will prove dependable.
The volume sequence should advance in a reasonably expected way, starting with nearly heavy volume as prices sink to form the low point of the left shoulder.
Once again, volume spikes as the stock hit a new low to form the point of the head. It is possible that volume at the head may be slightly lower than at the left shoulder.
When the right shoulder is forming, volume should be considerably lighter as the price of the stock once again moves lower.
It is most important to watch volume at the point where the neckline is broken. For a true reversal, experts agree that heavy volume is essential. You have to look for a “sharp burst” of the trading volume. This increase in volume marks an increase in demand at higher prices. Meaning, buyers have entered the market in greater numbers.
What are the details that you should pay attention to in the head and shoulders bottom?
Symmetry – In a classic head and shoulders bottom, the left and right shoulders hit their relative low points at approximately the same price and level. In addition, the shoulders are usually about the same distance from the head. Experts like to see symmetry but variations are not lethal to the validity of the pattern.
The wide variations between the shoulders are common in the pattern. The head, however, is noticeably symmetrical. If a shoulder hits the low point marked by the top of the head, the pattern is not a head and shoulders bottom.
Volume – As mentioned before, it is crucial to watch the volume sequence as this pattern develops.
The volume will usually be highest on the left shoulder and lowest on the right.
Investors, looking to ensure that volume increases in the direction of the trend, should ensure that a “burst” in volume occurs at the time the neckline is broken.
Experts declare that the volume pick-up at the end of the pattern is essential. But some experts, are not so convinced. A low volume
breakout is not an indicator of an impending failure.
Duration of Pattern – A bottoming pattern is usually longer in duration and less volatile than a top. In addition, price swings are more marked in tops than in bottoms.
The bottoms tend to be longer and flatter than tops. It is not unusual for a head and shoulders bottom to take several months to develop. Schabacker explains that volume activity in stocks is characteristically less after a period of declining prices than after a bull market. Because of this lower volume, patterns take
longer to form and tend to be smaller than tops.
Need for a Downtrend – This is a reversal pattern which marks the transition from a downtrend to an uptrend. The formation always begins during a major downtrend in the stock’s price.
The slope of the Neckline – In a well-formed pattern, the slope will not be too steep, but don’t automatically discount a formation with a steep neckline. Some experts believe an upward sloping neckline is more bullish than a downward sloping one. Others say slope has little to do with the stock’s degree of bullishness. The slope of a neckline can be too steep, however. An investor should consider the highest rise between the shoulders as the breakout level, rather than the piercing of the neckline.
Decisive Neckline Break – As mentioned earlier, the pattern is not complete until the neckline is broken and the breakout or confirmation must occur with a convincing burst of trading activity.
How can you trade this pattern?
Start by calculation the target price. Measure the height of the pattern by estimating the number of points vertically up from the bottom of the head to the neckline. Add this number to the point where prices finally break the neckline, noting the end of the right shoulder. The sum is the minimum price target.
To be more clear.
For example, assume the bottom of the head is 120 and the neckline vertically above it is 150. The height of the pattern is 30 (140 – 110 = 30). Assume the neckline was broken at 130. That means the upside objective is projected at 170 (140 + 30 = 170).
This target price of 170 is only a guide and can be affected by a variety of other factors already mentioned. Because this projected price is a minimum target, prices will often move beyond that objective.
If you can determine that a head and shoulders formation is completing, consider buying the stock. The formation rarely disappoints and the rise is worth betting on.
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