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Part 1: Head & Shoulders Bottom FormationImportant Characteristics of Head & Shoulders Bottom PatternExisting Trend:There should be an established existing DOWNWARD trend prior to the pattern.
Shape of Head & Shoulders Bottom Pattern:1) Head & Shoulders:Ideally, the shape Head & Shoulders should be symmetry. The Left & Right Shoulders should bottom at about the same price level. The Left & Right Shoulders should also about the same distance from the Head, which means the time duration to develop the formation between the bottom of Left Shoulder & the Head should be about the same as that between the Head & the bottom of Right Shoulder.
However, in the real world, the Shoulders are rarely perfectly symmetrical. Sometimes, one shoulder is lower than the other, or takes longer time to develop.
In any case, the Left or Right Shoulder should not reach the level of the Head. If it does, the formation is actually not Head & Shoulders Bottom pattern.
When the bottom of the Right Shoulder is higher than the bottom of the Left Shoulder, it may carry a higher chance of larger price increase after the breakout, as it implies more strength & bullish sentiments.
In addition, ideally, the shape Head & Shoulders should also be made up of three downward sharp bottoms. But in real world, the Shoulders can be a bit more rounded / flat.
Also, sometimes in a more complex formation, the pattern could have more than one head and/or more than two shoulders (e.g. 2 Left Shoulders with about the same size and 2 Right Shoulders that are more or less equivalent to the Left Shoulders). This more complex formation is more often seen in the Head & Shoulders Bottom than in the Head & Shoulders Top.
2) Neckline:
The Neckline that connects the two high points in between the Left Shoulder-Head and the Head-Right Shoulder can be horizontal, sloping upwards or downwards, but should not be too steep.
The slope of the Neckline could predict degree of bullishness of the pattern and hence affect the chance of stronger price increase.
A
downwards sloping Neckline has a weaker tendency that the price would increase further, as the lower high of the 2nd low point of the Neckline still indicates the strength of bearishness & market weakness, and thus it carries lower chance of stronger price increase.
An
upwards sloping Neckline, which rarely happens, is more reliable as a bullish reversal signal, as it may imply stronger bullish sentiments & more rapidly increasing market strength, and hence have a higher chance of stronger price increase.
Duration:
The duration of the formation of the pattern from the start of the development of Left Shoulder to the break of the Neckline can take several months, normally range from 3 to 6 months.
Normally, Head & Shoulders Bottom takes longer time to develop and less volatile in price swing than Head & Shoulders Top.
Hence, bottoms tend to be wider (due to longer duration to develop) and flatter (as a result of less volatile price swing) than tops.
Breakout:
Even when the price has increased from bottom of the Right Shoulder, the pattern is not completed yet. The chances that the existing downtrend will continue are still higher than the chances of reversal to take place, as it is normal during a downtrend for the price to test a support level a few times, and then bounce up, and then resume the downtrend again.
Head & Shoulders Bottom pattern is only completed and confirmed when the price increases and closes above the
Neckline, which serves as the key resistance level in this pattern.
Remember that we should always assume the existing trend (i.e. in this case is downtrend) is in force unless proven otherwise.
Therefore, it is important to wait for the price to make a decisive breakout by breaking through and closing above the Neckline resistance, accompanied with an increase in volume, in order to avoid jumping the gun and/or prevent deceptive Head & Shoulders Bottom pattern.
Nevertheless, since this pattern is considered as one of the most reliable pattern and has a relatively high success rate, some aggressive & experienced traders like to enter the market when the price is increasing from the bottom of the Right Shoulder, provided they are sure that a valid Head & Shoulders Bottom is forming. But of course, this trade is much riskier and not recommended for novice traders.
Breakout Confirmation:
Sometimes, the price may also make a deceptive/invalid breakout whereby it touches above the Neckline, but then it moves back down again & resumes downtrend.
One possible way to prevent this is by having certain criteria to confirm if the breakout is a valid one.
A minimum penetration criteria for a breakout should be the price closes ABOVE the Neckline resistance, not just an intraday penetration.
Some traders may apply certain price criteria (e.g. 3% - 5% break from the Neckline depending on the stock�s volatility) or time criteria (e.g. the breakout is sustained for 3 days) to confirm the validity of the breakout.
Traders / investors should be more cautious if the price keeps hovering around the Neckline without making a decisive break. When this happens, the reversal might never happen and the downtrend is likely to resume.
Volume:
Volume should be diminishing as the pattern is forming.
Volume is the highest during the formation of the Left Shoulder, and then gets lighter as the pattern develops the Head, and should be the lightest during the formation of Right Shoulder, showing an indication that the selling sentiments are getting weaker.
During & after the breakout of the Neckline support, the volume should significantly increase again.
Monitoring volume for Head & Shoulders Bottom is more crucial than in Head & Shoulders Top, as a breakout from the key resistance (i.e. Neckline) accompanied by an expansion in volume may indicate increased buying pressures and a potential change in sentiment from selling to buying. Hence, it may provide higher chances that the pattern is a reversal pattern.
When during the increase from bottom of the Right Shoulder, the price experiences an accelerated increase, perhaps with a gap up or two, accompanied by an expansion in volume, this might give a good sign, as the price increase tends to increase further, and hence it may provide higher chances that the pattern is a bullish reversal pattern.
Potential Price Target:
1) Compute the height of the pattern: The vertical distance between the bottom of the Head (which serves as the support) and the Neckline (which serves as the key resistance).
2) To compute the potential price target: Add the result to the point where the price finally breaks Neckline.
In general, any price target should only be used as a rough guide. To determine the price target, other factors, such as previous support / resistance levels, Fibonacci retracements, or long-term moving averages, should be considered as well.
Example:
Suppose a Head & Shoulders Bottom pattern is forming with the Neckline is sloping upward.
The bottom of the Head is at $50 and the Neckline vertically above it is at $65.
The height of the pattern is therefore 15 (= 65 - 50).
Suppose the Neckline was finally broken at $70.
Hence, the price target would be $85 (= 70 + 15).
Return to Breakout Level:
After the breakout occurs, the price may sometimes return to the Neckline for an immediate test of this new support level before continuing their moves in the direction of the breakout. (Remember that the resistance now has turned into new support level). It is also normally only a minor & short-lived retracement.
If this price return move happens, it could actually offer an opportunity to participate in the breakout with a better reward to risk ratio.
However, when the breakout occurs with a heavy volume, the chance of the price to return to the breakout level before continuing its upward movement will be smaller.
To find out more about other Chart Patterns, please refer to:
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