A head-and-shoulders bottom is considered a bullish signal. It indicates a possible reversal of the current downtrend into a new uptrend, and it’s a popular pattern with investors. This pattern marks a reversal of a downward trend in a security’s price.

Trading volume is absolutely crucial to a head-and-shoulders bottom. A trader 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 forms 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 trading volume sequence should progress beginning with relatively heavy volume as prices descend to form the low point of the left shoulder.

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.

The Options Trader’s Guide to Technical Analysis. Learn how to leverage the power of technical analysis to identify the short window when a trade is set to go straight up or down. Get your FREE copy here!