John Lansing

   

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 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 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. 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.

Variations of the Head-and-Shoulders Bottom

There are a few important variations of the head-and-shoulders bottom.

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