by John Lansing | June 1, 2012 9:15 am
A head-and-shoulders bottom is regarded as a bullish signal that indicates a possible reversal of a stock’s current downtrend into a new uptrend. It’s a popular pattern with traders.
Volume is critical for a head-and-shoulders bottom. A trader will be looking for increasing volumes at the breakout point. 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 head-and-shoulders bottom look like?
A perfect example of the head-and-shoulders bottom has three sharp low points created by three consecutive reactions in the price. It’s crucial that this pattern form following a major downtrend in the 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” — occurs 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” — happens when prices fall again but do not touch the low of the head. Prices rise again after they have hit the low of the right shoulder. The lows of the shoulders are decidedly higher than that of the head and, in a classic formation, are often more-or-less equal to one another.
The neckline is an important element of this pattern. The neckline is formed by drawing a line that connects the formation’s two high price points. The first high point occurs at the end of the left shoulder and the beginning of the downtrend to the head.
The second high point marks the end of the head and the beginning of the downturn to the right shoulder. The neckline typically points down in a head-and-shoulders bottom, but it can occasionally slope up.
The head-and-shoulders bottom is complete when the resistance marked by the neckline is “broken.” This happens when the stock’s price, rising from the low point of the right shoulder, moves up through the neckline. Many technical analysts consider the neckline “broken” only if the stock closes above the neckline.
The volume sequence should start 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. When the right shoulder is forming, volume should be definitively lighter, as the stock price once again moves lower.
It’s most important to watch volume at the point where the neckline is broken. For a true reversal, most experts concur that heavy volume is necessary.
There are a few important variations of the head-and-shoulders bottom.
Many valid head-and-shoulders patterns aren’t as well-defined as the classical “head” with a “shoulder” on each side. It’s not unusual to see more than two shoulders and more than one head.
The classic head-and-shoulders pattern is made up of three sharply pointed components — the head and two shoulders — but this isn’t always the case. Sometimes, the shoulders may not have sharp low points and will instead be quite rounded. This does not affect the pattern’s validity.
What details should you pay attention to in the head-and-shoulders bottom? Here are five:
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.
If you like technical trading, then be sure to check out Parabolic Options with John Lansing. John is an outstanding technical trader and educator.
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