Chart Patterns is a new series of Market School posts that we will be releasing in the coming weeks.
A Head and Shoulders Bottom is considered a bullish signal. It indicates a possible reversal of the current downtrend into a new uptrend.
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.
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.
Following are important characteristics for this pattern.
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.
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.
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.
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.
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 Support
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 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 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 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 Refute
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.