How to Trade the Head-and-Shoulders Bottom
Consider the duration of the pattern and its relationship to the length of time you prefer to hold a trade, especially considering options expiration dates.
Most consider the duration of the pattern a relevant 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. The shorter the pattern, the sooner the price is likely to move.
If you’re considering a short-term trading opportunity, look for a pattern with a short duration. If you prefer 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 offers a significant indication about the potential price move that the head-and-shoulders pattern indicates. Consider whether the target price for this pattern is enough to yield adequate returns after your costs (such as commissions and taxes) have been taken into account.
A good rule is that the target price must specify a potential return of greater than 5% before a pattern should be considered useful. However, you must keep in mind the current price and the volume of shares or contracts you intend to trade. Also, check that the target price has not already been hit.
The inbound trend is an important characteristic of the pattern. A shallow inbound trend may suggest consolidation before the price move indicated by the pattern commences. Look for an inbound trend that is longer than the duration of the pattern. A good general rule is that the inbound trend should be at least two times the duration of the pattern.
Criteria That Supports the Head-and-Shoulders Bottom
- Support and Resistance — Aim to find a region of support or resistance around the target price, which 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 stock’s moving average. Compare the location of the pattern to a moving average of similar length. For short duration patterns, use the 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 the pattern indicates. For short-duration patterns, use the 50-day moving average. For longer patterns, use the 200-day moving average.
- Volume — Volume will usually be highest on the left shoulder and lowest on the right shoulder. A strong spike in volume spike on the day of the pattern confirmation is a strong indicator that supports the potential for this pattern. The volume spike should be notably above the volume average for the pattern’s duration.
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