Head and Shoulders Bottom Chart Pattern

Implication


A Head and Shoulders Bottom is considered a bullish signal. It indicates a possible reversal of the current downtrend into a new uptrend.


Description

The Head and Shoulders bottom is a popular pattern with investors. This pattern marks a reversal of a downward trend in a financial instrument’s price.

Volume is absolutely crucial to a Head and Shoulders Bottom. An investor will be 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.

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 first point - the left shoulder - occurs as the price of the financial instrument 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 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.

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.

The volume sequence should progress beginning with relatively heavy volume as prices descend to form the low point of the left shoulder. Once again, volume spikes as the stock hits 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, however, volume should be markedly 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.

Variations of the Head and Shoulders Bottom

There are a few notable variations for this pattern.

Multiple Head and Shoulders Patterns

Many valid Head and Shoulders patterns are not as well defined as the classical head with a shoulder on either side. It is not uncommon to see more than two shoulders and more than one head. A common version of a multiple Head and Shoulders pattern includes two left shoulders of more or less equal size, one head, and then two right shoulders that mimic the size and shape of the left shoulders.

Flat Shoulders

The classic Head and Shoulders pattern is made up of three sharply pointed components - the head and two shoulders. This is not always the case. Sometimes, the shoulders can lack sharp low points and instead be quite rounded. This does not affect the validity of the pattern.

Important Characteristics

Following are important characteristics for this pattern.

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.

Volume

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.

Duration of Pattern

It is not unusual for a Head and Shoulders bottom to take several months to develop. Volume activity in stocks is characteristically less after a period of declining prices than after a bull market. Because of this lower volume, bottoms 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.

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.

Trading Considerations

Duration of the Pattern

Consider the duration of the pattern and its relationship to your trading time horizons. The duration of the pattern is considered to be an indicator of the duration of the influence of this pattern. The longer the pattern the longer it will take for the price to reach the Target Price. The shorter the pattern the sooner the price move. If you are considering a short-term trading opportunity, look for a pattern with a short duration. If you are considering a longer-term trading opportunity, look for a pattern with a longer duration. The duration of the pattern is sometimes called the "width" or "length" of the pattern.

Target Price

The target price provides an important indication about the potential price move that this pattern indicates. Consider whether the target price for this pattern is sufficient to provide adequate returns after your costs (such as commissions) have been taken into account. A good rule of thumb is that the target price must indicate a potential return of greater than 5% before a pattern should be considered useful. However you must consider the current price and the volume of shares you intend to trade. Also, check that the target price has not already been achieved.

Inbound Trend

The inbound trend is an important characteristic of the pattern. A shallow inbound trend may indicate a period of consolidation before the price move indicated by the pattern begins. Look for an inbound trend that is longer than the duration of the pattern. A good rule of thumb is that the inbound trend should be at least two times the duration of the pattern.

Criteria that Supports

Support and Resistance

Look for a region of support or resistance around the target price. A region of price consolidation or a strong Support and Resistance Line at or around the target price is a strong indicator that the price will move to that point.

Location of Moving Average

The Head and Shoulders Bottom should be be below the Moving Average. Compare the location of the pattern to a Moving Average of appropriate length. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average.

Moving Average Trend

The Moving Average should change direction within the duration of the pattern and should head in the direction indicated by the pattern. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average.

Volume

Volume will usually be highest on the left shoulder and lowest on the right.

A strong volume spike on the day of the pattern confirmation is a strong indicator in support of the potential for this pattern. The volume spike should be significantly above the average of the volume for the duration of the pattern.

Other Patterns

Other reversal patterns (such as Bullish and Bearish Engulfing Lines and Islands) that occur at the peaks and valleys indicate strong resistance at those points. The presence of these patterns inside a Head and Shoulders is a strong indication in support of this pattern.

Criteria that Refutes

No Volume Spike on Confirmation

The lack of a volume spike on the day of the pattern confirmation is an indication that this pattern may not be reliable. In addition, if the volume has remained constant, or was increasing, over the duration of the pattern, then this pattern should be considered less reliable.

Location of Moving Average

If the Head and Shoulders Bottom is above the Moving Average then this pattern should be considered less reliable. Compare the location of the pattern to a Moving Average of appropriate length. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average.

Moving Average Trend

Look at the direction of the Moving Average Trend. For short duration patterns use a 50 day Moving Average, for longer patterns use a 200 day Moving Average. A Moving Average that is trending in the opposite direction to that indicated by the pattern is an indication that this pattern is less reliable.

Short Inbound Trend

An inbound trend that is significantly shorter than the pattern duration is an indication that this pattern should be considered less reliable.

Examples

Alaska Air Group, Inc. (ALK) formed a head and shoulders bottom with a downward sloping neckline. Key points include:


  1. The stock began a downtrend in early July, and declined from 60 to 26.
  2. The low of the left shoulder formed with a large spike in volume on a sharp down day (red arrows).
  3. The reaction rally at around 42 1/2 formed the first point of the neckline (1). Volume on the advance was respectable with many gray bars exceeding the 60-day SMA. (Note: gray bars denote advancing days, black bars declining days and the thin red horizontal is the 60-day SMA).
  4. The decline from 42 1/2 to 26 (head) was quite dramatic, but volume did not get out of hand. Chaikin Money Flow was mostly positive when the lows around 26 were forming.
  5. The advance off of the low saw a large expansion of volume (green oval) and gap up. The strength behind the move indicated that a significant low formed.
  6. After the reaction high around 39, the second point of the neckline could be drawn (2).
  7. The decline from 39 to 33 occurred on light volume until the final two days, when volume reached its highest point in a month. Even though there are two long black (down) volume bars, these are surrounded by above-average gray (up) volume bars. Also notice how trend line resistance near 35 became support around 33 on the price chart.
  8. The advance off of the low of the right shoulder occurred with above average volume. Chaikin Money Flow was at its highest levels, and surpassed +20% shortly after neckline resistance was broken.
  9. After breaking neckline resistance, the stock returned to this newfound support with a successful test around 35 (green arrow).
AT&T (T) formed a head and shoulders bottom with a flat neckline. The shoulders are a bit shallow, but the neckline and head are well pronounced. Key points include:


  1. The stock established a 6-month downtrend with the trend line extending down from Mar-98.
  2. After a head fake above the trend line in late June, the stock fell from 66 to 50 with a sharp increase in volume to form the left shoulder.
  3. The rally to 61 met resistance from the trend line, and the reaction high became the first point of the neckline.
  4. The decline from 61 to 48 finished with a piercing pattern to form the low of the head. Even though volume was heavy when the long black candlestick formed, the subsequent reversal occurred on even higher volume. This reversal was followed with a number of strong advances and up gaps. Also notice that Chaikin Money Flow was above +10% when the low of the head formed.
  5. The advance from the low of the head broke above the trend line, extending down from Mar-98, and met resistance around 61. This reaction high formed the second point of the neckline.
  6. The right shoulder was quite short and shallow. The low was recorded at 57 and Chaikin Money Flow remained above +10% the whole time. Support was found from the trend line that offered resistance a few weeks earlier.
  7. The stock advanced sharply off of lows that formed the right shoulder, and volume increased three straight days (blue arrow). This is a bit early, but volume remained just above average for the neckline breakout a few days later. Also Chaikin Money Flow remained above +10% the whole time.
  8. After the break of neckline resistance, the stock tested this newfound support twice while consolidating recent gains. The power arrived a few weeks later with a strong move off support and a huge increase in volume. The stock subsequently advanced from the low sixties to the low eighties.
Head and Shoulder Bottoms are one of the most common and reliable reversal formations. It is important to remember that they occur after a downtrend and usually mark a major trend reversal when complete. While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. Shoulders can be different widths as well as different heights. Keep in mind that technical analysis is more an art than a science. If you are looking for the perfect pattern, it may be a long time coming.

Analysis of the Head and Shoulders Bottom should focus on correct identification of neckline resistance and volume patterns. These are two of the most important aspects to a successful read, and by extension a successful trade. The neckline resistance breakout combined with an increase in volume indicates an increase in demand at higher prices. Buyers are exerting greater force, and the price is being affected.

As seen from the examples, traders do not always have to chase a stock after the neckline breakout. Often, but certainly not always, the price will return to this new support level and offer a second chance to buy. Measuring the expected length of the advance after the breakout can be helpful, but don’t count on it for your ultimate target. As the pattern unfolds over time, other aspects of the technical picture are likely to take precedent. Technical analysis is dynamic, and your analysis should incorporate aspects of the long-, medium- and short-term picture.

Sources and additional information:
http://www.trending123.com/patterns/inverted_head_and_shoulders.html
http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:chart_patterns:head_and_shoulders_b
http://www.baresearch.com/education/technical_analysis/chart_patterns/reversal/hs_bottom.php
http://www.thestockbandit.com/Head-shoulders-bottom.htm

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