Introduction What does a classic head and shoulders bottom look like? Is volume important in a head and shoulders bottom? What are the details that I should pay attention to in the head and shoulders bottom? How can I trade this pattern? Are there variations in the pattern I should know about?

Introduction

Like the head and shoulders top, the head and shoulders bottom is a popular pattern with investors. The reverse of the head and shoulders top, the bottom marks a reversal in a downward trend in a stock's price -... In fact, Elaine Yager, Director of Technical Analysis at Investec Ernst and Company in New York and a member of Recognia's Board of Advisors, holds that this pattern most commonly occurs during the reversal of a major trend, a trend that has been in existence for a year or more.

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 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.

What does a classic head and shoulders bottom look like?

As shown below, the head and shoulders bottom, also referred to as an inverse head and shoulders, looks like a top, except reversed. A perfect example of the head and shoulders bottom has three sharp low points created by three successive reactions in the price of the stock. It is essential that this pattern form following a prior major downtrend in a stock's price.

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.

Is volume important in a head and shoulders bottom?

It is crucial for an investor to monitor the volume pattern to determine if what looks like a forming head and shoulders bottom will prove dependable.

The volume sequence should progress in a fairly predictable way, 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. Murphy advises looking for a "sharp burst" of trading volume¹. This increase in volume marks an increase in demand at higher prices. Buyers have entered the market in greater numbers.

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. Experts like to see symmetry but variations are not lethal to the validity of the pattern. Bulkowski comments that wide variations between the shoulders (they can vary in height or width) are common in the pattern. The head, however, is noticeably symmetrical.² If a shoulder hits the low point marked by the top of the head, the pattern is not a head and shoulders bottom.

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.
  
  
• Experts, including Murphy, maintain that the volume pick-up at the end of the pattern is essential. "If the volume pattern does not show a significant increase during the upside price breakout, the entire pattern should be questioned."³ Other experts, including Bulkowski, are not so convinced: "a low volume breakout is not an indicator of an impending failure."⁴

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.⁵ It is not unusual for a head and shoulders bottom to take several months to develop. Schabacker explains that volume activity in stocks is characteristically less after a period of declining prices than after a bull market. Because of this lower volume, patterns take longer to form and tend to be smaller than tops.⁶

4. Need for a Downtrend - This is a reversal pattern which marks the transition from a downtrend to an uptrend. According to Yager, the formation always begins during a major downtrend in the stock's price.

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.⁷ 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.⁸ The slope of a neckline can be too steep however. Bulkowski recommends that if a neckline is too steep, an investor should consider the highest rise between the shoulders as the breakout level, rather than the piercing of the neckline.⁹

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.

How can I trade this pattern?

Begin by computing the target price. Compute the height of the pattern by measuring the number of points vertically up from the bottom of the head to the neckline. Add this number to the point where prices finally break the neckline, marking the end of the right shoulder. The sum is the minimum price target.

For example, assume the bottom of the head is 110 and the neckline vertically above it is 140. The height of the pattern is 30 (140 - 110 = 30). Assume the neckline was broken at 130. That means the upside objective is projected at 160 (130 + 30 = 160). This target price of 160 is only a guide and can be affected by a variety of other factors already mentioned. Because this projected price is a minimum target, prices will often move beyond that objective.

Yager uses two measurements, one to confirm the formation of the pattern and one to compute a target price. As in the calculation above, compute the height of the pattern by measuring the number of points vertically up from the bottom of the head to the neckline. Take the height and add it to the price which marks the bottom of the right shoulder. This calculation should be done only when the price has penetrated the neckline. The pattern is confirmed when this price target is reached.

Then take the height and add it to the neckline marking the end of the right shoulder. This second measurement is the price objective.

For example, assume the bottom of the head is 110 and the neckline vertically above it is 140. The height of the pattern is 30 (140 - 110 = 30). Assume the bottom of the right shoulder is 120 and the neckline was broken at 130. The confirmation point is therefore 150 (120 + 30 = 150) and the upside objective is projected at 160 (130 + 30 = 160). Bulkowski suggests modifying this calculation method in situations where the neckline is particularly steep and up-sloping. "Substitute the rise between the head and right shoulder (that is the highest price in the rise) for the neckline breakout price."¹⁰ Bulkowski's advice is in keeping with his aggressive approach to trading a head and shoulders bottom.

According to Bulkowski, "if you can determine that a head and shoulders formation is completing, consider buying the stock. The formation rarely disappoints and the rise is worth betting on."¹¹ He does continue, however, to caution potential investors to first be sure that what they are looking at is a true head and shoulders bottom. If you're unsure, he advises, wait for the breakout at the neckline.

Schabacker advises patience when monitoring the development of this pattern. He bases this on the fact that a head and shoulders bottom tends to take longer to form and is smaller in size to a head and shoulders top. Don't expect the time frames for pattern development to mimic that of the head and shoulders top.¹² Murphy suggests the investor use this difference to his or her advantage. Because of the smaller price ranges and slower development time, "it is usually easier and less costly to identify and trade bottoms than to catch market tops."¹³ Although, he concludes, because prices tend to decline faster than they go up, an investor can reap greater rewards trading a head and shoulders top. This greater reward is accompanied by greater risk.

Murphy is adamant that increasing volume is a critical confirming pattern in the completion of a head and shoulders bottom. "If the volume pattern does not show a significant increase during the upside price breakout, the entire pattern should be questioned." ¹⁴

Bulkowski advises investors that if they miss the upside breakout, they should wait and watch. They may not have lost a trading opportunity. "Half the time, the stock will throw back to the neckline. Once it does, buy the stock or add to your position." ¹⁵

Edwards and Magee call a close above the neckline break of approximately 3% of the stock's market price the "breakout" or "confirmation" of the head and shoulders bottom.¹⁶

Are there variations in the pattern I should know about?

There are a few notable variations:

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. "Complex" formations can have more variations than the classical formation. It is not uncommon to see more than two shoulders and more than one head. Edwards and Magee advise that any combination is possible, but it's more common to see multiple head and shoulders with a bottom rather than a top.¹⁷

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. "The point to note," explains Schabacker, "is simply that the stock is trying to continue its previous main movement but is restrained from doing so on successive occasions by the development of technical power or pressure in the opposite direction."¹⁸

¹Murphy, p. 112
²Bulkowski, p. 265
²Murphy, p. 103
⁴Bulkowski, p. 265
⁵Edwards and Magee, p. 81
⁶Schabacker, p. 53
⁷Bulkowski, p. 267
⁸Bulkowski, p. 271
⁹Bulkowski, p. 265
¹⁰Bulkowski, p. 273
¹¹Bulkowski, p. 273
¹²Schabacker, p. 53
¹³Murphy, p. 103
¹⁴Murphy, p. 103
¹⁵Bulkowski, p. 273
¹⁶Edwards and Magee, p. 81
¹⁷Edwards and Magee, p. 85
¹⁸Schabacker, p. 57