« ~~ Head & Shoulders Bottom ~~ »

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INTRODUCTION 

The head and shoulders bottom, also known as inverse head and shoulders, is considered a significant bullish reversal pattern, the occurrence of which usually signals the end of a major downtrend. The pattern is mainly characterized by three successive troughs, of which the middle trough - the "head' - is the deepest. The resistance line that connects the intervening peaks is called the ‘neckline’.

In many ways, the head and shoulders bottom is a mirror image of the head and shoulders top. However, the role of volume, especially that seen in the second half of the pattern, is much more significant in the case of the bottom.

FORMATION

Left Shoulder and Head 

In the lead-up to a bottoming pattern that would later turn out to be a head and shoulders bottom, the chartist witnesses a major downtrend wherein prices form a series of lower peaks and lower troughs (of which the last two will later be seen as the ‘left shoulder’ and the ‘head’, respectively). During this phase, volume is often high when prices are declining and low when prices are correcting upwards. 

At a certain point, a rush of buying pressure emerges and price goes on to break out of the downtrend. At this point, the chartist begins to consider the possibility of a reversal in trend.

Neckline 

After the breaking of the downtrend, price attempts to rally above the level of the most recent reaction high (A). However, despite the apparent change in momentum, prices are not quite able to break above that level and they start to decline after putting in a new reaction high (B). This time around, the meeting of resistance does not instigate heavy selling pressure and price quickly finds support around the level of the first trough. The resistance line that joins points A and B will later be known as the ‘neckline’. 

Additionally, the chartist finds that the recent dip (from B) has come with markedly lower volume than that seen during the previous declines. The chartist finds this non-confirmation to be a significant finding and now, for the first time during this move, he starts to believe that a potential head and shoulders bottom might be in the making.

Right Shoulder and Breakout Above Neckline  

The next step in the formation of this pattern is a breaking of the resistance line - the neckline - of what is now recognized as a bonafide ‘head and shoulders bottom’. 

A significant change in trend is potentially on the cards and the chartist now needs to pay close attention to a couple of important details that will help ascertain the validity of this pattern. One of the most important aspects looked at by the chartist is that of the volume trend that accompanies the breaking of the neckline.

The difference between tops and bottoms, in general, is that significant buying pressure is required in order to confirm the formation of a bottom whereas a top might be formed without a significant increase in volume. The preferred volume trend coincidental to the breaking of an inverse head and shoulders' neckline is no different. A massive increase in trading volume is desired, such that any attempt at resisting a change in trend might be thwarted.

Return Move  

Often, the final step in the confirmation of a head and shoulders pattern is the occurrence of a ‘return move’. The return move is more common at bottoms than at tops.  

After breaking the neckline, price often falls back and “tests” the neckline, This test should occur on light volume, representing a lack of supply interest, and should ideally not violate the neckline on a closing basis. If either volume is high or neckline support is violated, the chartist needs to consider the possibility that the pattern is about to fail. 

However, if the pattern is legitimate, the neckline provides support and a rally ensues. This rally is often accompanied by increased trading volume, which confirms renewed bullish interest in the asset depicted by the chart.

OTHER SIGNIFICANT ASPECTS

Volume

The behaviour of volume during a head and shoulders bottom is a crucial determinant of the pattern’s success. Typically, the level of volume coincidental to the formation of each new trough – left shoulder, head and right shoulder – tends to be lighter than that which came with the trough before it. Additionally, the rally out of the lows of the head often sees higher activity than the rally out of lows of the left shoulder. 

The essential piece of the puzzle, however, is the volume seen during the rally out of the right shoulder. There needs to be a substantial increase in trading activity as price bursts through the neckline. Only then can the breakout be considered trustworthy.

The return move is typically on light volume and is followed by a hoard of buying, which confirms the new price uptrend. It is important to remember that the validity of a head and shoulders bottom that is not confirmed by desired volume behaviour might be questionable. The chartist is especially interested in seeing an eruption in volume coincidental to the breaking of the neckline.

Duration of Formation

While a head and shoulders top typically takes 3 to 6 months to form, a head and shoulders bottom typically takes a little longer to complete.

Slope of Neckline 

While a head and shoulders top often has a horizontal neckline, head and shoulder bottoms often display a slightly downward sloping one. A horizontal or upward sloping neckline might portend greater market strength; however, having that characteristic might also carry with it the disadvantage of offering a signal later than would otherwise be the case.

VARIATIONS IN FORM 

As mentioned earlier, the typical head and shoulders bottom has a downward sloping neckline. Occasionally, however, other variants such as a horizontal or upward sloping neckline may be seen. There is also another variation of a different kind – the complex head and shoulders bottom. This variant is different in that it contains several shoulders and/or heads within the main formation..

SETTING UP THE TRADE & FINDING A PROFIT OBJECTIVE 

There are a couple of ways in which a head and shoulders pattern may be traded. Some traders tend to buy the neckline breakout (E), others use a successful return move (F) as a buying opportunity. Aggressive traders might even forerun a confirmation and buy the first move off support from the right shoulder (G).

Regardless of the trigger used to enter the trade, the method used in setting a target is most often the vertical distance or height method. Herein, the trader measures the vertical distance (in terms of points or percentage points) between the low of the head (D) and the neckline (C), and then projects that distance from the level of the neckline breakout (E) to arrive at a target for the trade. Once prices start to rise, the trader protects long positions by placing a stop just below the neckline.

ILLUSTRATION 

NOK formed a complex head and shoulders bottom with a downward sloping neckline, in 2002. A textbook-perfect formation is extremely rare, but this chart came pretty close..

The stock had been in a downtrend that began in January at 25.0 and ended in August at 10.0. The trough of the left shoulder, which formed over a couple of weeks in June, saw an increase in trading volume. 

The reaction rally from the left shoulder peaked at around 14.75 and was accompanied by decent trading activity. The decline into the head (from 14.75 to 10.0) was accompanied by above-average volume. The stock then made a small double bottom on light volume and consequently started to rally. 

The move off the lows of the head barely saw an increase in volume (unlike what would happen in a perfect textbook case) and peaked at 14.25 

The decline into the right shoulder was not greeted with much trading interest and the stock found support at around 11.30.

This was followed by a rally out of the right shoulder that came with gradually increasing volume and provided a decisive breaking of the neckline (in mid-Oct) on heavy volume. 

There was even a quick one-day return move, which was immediately followed by an up-gap, and a strong continuation in the rally. 

The target, which was calculated by projecting the height of the head (14.75-10.25= 4.5 pts) from the level of the neckline breakout (14.0), was 18.5. This target was eventually reached in late-November, barely 6 weeks after the breakout.