Head and Shoulders Bottom
Understanding Head and Shoulders Bottom Pattern
The Head and Shoulders Bottom, sometimes referred to as an Inverse Head and Shoulders, is a reversal pattern that shares many common characteristics with the Head and Shoulders Top but relies more heavily on volume patterns for confirmation.
Head and Shoulders Bottom
As a major reversal pattern, the Head and Shoulders Bottom forms after a downtrend, with its completion marking 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 price action that forms the Head and Shoulders Bottom is roughly the same as that which forms the Head and Shoulders Top, but reversed. The role of volume marks the biggest difference between the two. Generally speaking, volume plays a larger role in bottom formations than top formations. While an increase in volume on the neckline breakout for a Head and Shoulders Top is welcomed, it is absolutely required for a bottom. We will look at each part of the pattern individually, keeping volume in mind.
- Prior Trend: It is important to establish the existence of a prior downtrend for this to be a reversal pattern. Without a prior downtrend to reverse, there cannot be a Head and Shoulders Bottom formation.
- Left Shoulder: While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the formation of the left shoulder (1). The high of the decline usually remains below any longer trend line, thus keeping the downtrend intact.
- Head: From the high of the left shoulder, a decline begins that exceeds the previous low and forms the low point of the head. After making a bottom, the high of the subsequent advance forms the second point of the neckline (2). The high of the advance sometimes breaks a downtrend line, which calls into question the robustness of the downtrend.
- Right Shoulder: The decline from the high of the head (neckline) begins to form the right shoulder. This low is always higher than the head, and it is usually in line with the low of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack, and the right shoulder will be higher, lower, wider, or narrower. When the advance from the low of the right shoulder breaks the neckline, the Head and Shoulders Bottom reversal is complete.
- Neckline: The neckline forms by connecting reaction highs 1 and 2. Reaction High 1 marks the end of the left shoulder and the beginning of the head. Reaction High 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two reaction highs, the neckline can slope up, slope down, or be horizontal. The slope of the neckline will affect the pattern’s degree of bullishness: an upward slope is more bullish than a downward slope.
- Volume: While volume plays an important role in the Head and Shoulders Top, it plays a crucial role in the Head and Shoulders Bottom. Without the proper expansion of volume, the validity of any breakout becomes suspect. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing the absolute levels associated with each peak and trough.
- Neckline Break: The Head and Shoulders Bottom pattern is not complete (and the downtrend is not reversed) until neckline resistance is broken. For a Head and Shoulders Bottom, this must occur in a convincing manner, with an expansion of volume.
- Resistance Turned Support: Once resistance is broken, it is common for this same resistance level to turn into support. Often, the price will return to the resistance break, and offer a second chance to buy.
- Price Target: After breaking neckline resistance, the projected advance is found by measuring the distance from the neckline to the bottom of the head. This distance is then added to the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should be considered, as well. These factors might include previous resistance levels, Fibonacci retracements or long-term moving averages.
Points to Remember
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 of 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.