How to Trade Head-and-Shoulders Above the Rest

The head-and-shoulders bottom chart pattern – is generally regarded as a possible reversal of a stock’s current downtrend and into a new uptrend. And if there is one thing that nearly every market observer needs to find right now, it’s stocks on the verge of a possible reversal.

The head-and-shoulders pattern is a popular pattern with traders, but there are a few things key to understanding this picture. First, just what does a head-and-shoulders bottom look like?

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A perfect example of the head-and-shoulders bottom has three sharp low points created by three consecutive reactions in the price. It is 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 start to 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.

Head and Shoulders Bottom Bullish Chart

A Classic Head-and-Shoulders Bottom Pattern

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. 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 point may be somewhat lower than at the left shoulder. However, when the right shoulder is forming, volume should be definitively lighter, as the stock price once again moves lower.

It is 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, such as:

1. Multiple Head-and-Shoulders-Patterns: Many valid head-and-shoulders patterns are not as well defined as the classic “head” with a “shoulder” on each side. It is not unusual to see more than two shoulders and more than one head. A common version of a multiple head-and-shoulders pattern includes two left shoulders of generally equal size, one head, and then two right shoulders that mirror the size and shape of the left shoulders.

2. Flat Shoulders: 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 I Pay Attention to in the Head-and-Shoulders Bottom?

If you go hunting for the head-and-shoulders bottom patterns in your trading, there are a few details you should always look for.

1. Symmetry: In a classic head-and-shoulders bottom, the left and right shoulders hit their relative low points at about the same price and level. Additionally, the shoulders are typically about the same distance from the head. I prefer to see symmetry, but variations do not necessarily dismiss the pattern’s validity.

2. Volume: It is imperative to watch the volume sequence as the pattern develops. Volume will usually be highest on the left shoulder and lowest on the right. Traders who look to ensure that volume increases in the direction of the trend should make sure that a “burst” in volume occurs at the time the neckline is broken.

3. Duration of Pattern: It is not unusual for a head-and-shoulders bottom to take several months to fully develop. A stock’s volume is generally lower after a period of declining prices than after a bull market. Because of this lower volume, bottoms take longer to form and tend to be smaller than tops.

4. The Need for a Downtrend: This is a reversal pattern that marks the transition from a downtrend to an uptrend. As of this writing (Oct. 29), there’s no way we can confidently call an end to the downtrend just yet.

5. Slope of the Neckline: In a well-formed pattern, the slope won’t be too steep, but be sure not to automatically discount a formation that has a steep neckline. Some experts believe an upward sloping neckline is more bullish than a downward sloping one. Others say, however, that slope has very little to do with the degree of the stock’s bullishness.

Given the decline in equities in 2008, it’s pretty safe to assume that most necklines will slope decidedly downward.

Helpful Hints for a Good Head-and-Shoulders Bottom Play

The first hint to a good head-and-shoulders trade is to consider the duration of the pattern and its relationship to the length of time you prefer to hold a trade. Most traders 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 your target price. The shorter the pattern, the sooner the price is likely to move.

If you are 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.

Another hint is that 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.

The steep decline in the equities market throughout this tough 2008 will undoubtedly create a whole lot of head-and-shoulders patterns when the market does eventually make a comeback. By studying up now on how to identify this bullish pattern, you’re getting yourself prepared for some big winning trades.

John Lansing is the creator of Trending123,the multimedia hub for technical analysis trading, to help traders and investors target the best stocks and commodities. His insight and analysis can also be found online at the Options Web site.