Head and Shoulders bottom pattern is a decline to a new low and rally to intermediate resistance, a second decline to a lower low and rally to resistance followed by a modest third decline and rally through resistance.
The technical target for a head and shoulders bottom pattern is derived by adding the difference between the neckline and the lowest level achieved in the formation of the "head" to the new breakout level.
• Symmetry is Important. The most reliable head and shoulders top patterns are symmetrical, that is the left and right shoulders take shape over roughly the same number of days. Patterns with extended right shoulders should be avoided.
• It is important that volume decline on each successive phase of the head and shoulders bottom pattern and surge on the break above the neckline. The weak volume and declining price is a good indication that accumulation is at work.
• No pattern is truly complete until there is a breakout close above the neckline of the pattern.
• Upside breakouts often lead to small 2-3% rallies followed by an immediate test of the breakout level. If the stock closes below this level (now support) for any reason the pattern becomes invalid.
Head and Shoulders patterns are among the most important of reversal patterns because they are both common and reliable. The head and shoulders bottom pattern consists of three declines and a breakout. This reversal pattern, sometimes called the inverted Head and Shoulders pattern, gets its name because it is the inverse of the head and shoulders top pattern.
The "left shoulder" of a head and shoulders bottom pattern will always take shape after an extended decline to new lows. Against the backdrop of increasing unfavorable fundamental developments the stock sinks to one low after another, investors become decidedly bearish.
The first phase of the head and shoulders bottom pattern is usually the product of a particularly negative fundamental development. Although the stock is already well off its recent highs, this new negative development seems to be beyond the scope of most investors. The stock immediately sinks to a new low on very strong volume. Despite the bad news, the decline is short-lived because serious longer-term investors begin to establish positions. Just days later the imbalance between buyers and sellers leads to a brisk rally to an intermediate term resistance level. Technicians call this rally the
reaction high because it is a reaction to the initial decline to new lows. This price action also completes the left shoulder of the pattern.
Because all of the fundamental news remains bearish, investors and analysts rationalize that the stock had simply fallen too
far and days later the decline resumes. The stock falls to a new low but volume is substantially diminished, selling pressures are drying-up. The weak volume on the decline and the new lower prices encourages buyers, very soon a new rally develops and the stock once again moves toward the reaction high (overhead resistance level). This price action completes the head of the pattern. Once again sellers return amid poor fundamental news. This may be a negative corporate development or an analyst downgrade but the stock starts to drift lower for a third time.
As price falters, volume diminishes substantially again and buyers reassert themselves, forcing a rally back to the overhead resistance level. This price action completes the third a final phase of the pattern, the right shoulder. The negative
comments from Wall Street analysts continue but this time buyers overwhelm sellers and the stock surges through resistance. Weeks later the stock rallies to longer-term resistance.
The head and shoulders bottom marks a reversal in a downward trend in a stock's price. While volume is important to a head and shoulders top, it is absolutely crucial to a head and shoulders bottom. An investor will be looking forincreasing 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.
What does a classic head and shoulders bottom look like?
The first point,- the left shoulder, -occurs as the price of the stock in a falling market hits a new low and then rises in a minor recovery. The second point, -the head, happens when prices fall from the high of the left shoulder to an even lower level and then rise again. The third point, -the right shoulder, -occurs when prices fall again but don't hit the low of the head. Prices then rise again once they have hit the low of the right shoulder. The lows of the shoulders are definitely higher than that of the head and, in a classic formation, are often roughly equal to one another.
The neckline is a key element of this pattern. The neckline is formed by drawing a line connecting 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.
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.
What are the details that I should pay attention to in the head and shoulders bottom?
There are certain characteristics that experts like to see in the pattern.
1. 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.
2. Volume - As mentioned earlier, it is critical to watch the volume sequence as this pattern develops.
· 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.
3. 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. According to Edwards and Magee, 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.
4. Need for a Downtrend - This is a reversal pattern which marks the transition from a downtrend to an uptrend.
5. 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.
6. 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.