Head and Shoulders Bottom
Discover how to recognize and interpret the Head and Shoulders Bottom reversal pattern. Explore its anatomy, formation, and implications with this in-depth guide from StockCharts' ChartSchool.
The Head and Shoulders Bottom is a major reversal pattern that forms after a downtrend. A completion of the pattern marks a trend change. The pattern contains three successive troughs with the middle trough (head) being the deepest and the two outside troughs (shoulders) being shallower. Ideally, the two shoulders would be equal in height and width. The reaction highs in the middle of the pattern can be connected to form resistance, or a neckline.
The price action that forms the Head and Shoulders Bottom is similar to the Head and Shoulders Top, but reversed. Volume action is the main difference between the two. Generally speaking, volume plays a larger role in bottom formations than top ones. While an increase in volume on the neckline breakout for a Head and Shoulders Top is welcomed, it is absolutely required for a bottom. We will look at each component of the pattern, keeping volume in mind. Then we'll put the parts together with some examples.
Prior Trend. For this to be a reversal pattern, it is important to establish the existence of a prior downtrend. Without a prior downtrend to reverse, there cannot be a Head and Shoulders Bottom formation.
Left Shoulder. While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the left shoulder formation (1). The high of the decline usually remains below any longer trend line, thus keeping the downtrend intact.
Head. From the high of the left shoulder, a decline begins that exceeds the previous low and forms the low point of the head. After making a bottom, the high of the subsequent advance forms the second point of the neckline (2). The high of the advance sometimes breaks a downtrend line, which calls into question the robustness of the downtrend.
Right Shoulder. The decline from the high of the head (neckline) begins to form the right shoulder. This low is always higher than the head and is usually in line with the low of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack, and the right shoulder will be higher, lower, wider, or narrower. When the advance from the low of the right shoulder breaks the neckline, the Head and Shoulders Bottom reversal is complete.
Neckline. The neckline forms by connecting reaction highs 1 and 2. Reaction High 1 marks the end of the left shoulder and the beginning of the head. Reaction High 2 marks the end of the head and beginning of the right shoulder. Depending on the relationship between the two reaction highs, the neckline can slope up, slope down, or be horizontal. The slope of the neckline will affect the pattern's degree of bullishness: an upward slope is more bullish than a downward slope.
Volume. While volume plays an important role in the Head and Shoulders Top, it plays a crucial role in the Head and Shoulders Bottom. Without the proper expansion of volume, the validity of any breakout becomes suspect. Volume can be measured as an indicator (OBV, Chaikin Money Flow) or simply by analyzing the absolute levels associated with each peak and trough.
Volume levels during the first half of the pattern are less important than in the second half. Volume on the decline of the left shoulder is usually pretty heavy, and selling pressure is intense. The intensity of selling can continue during the decline that forms the low of the head. After this low, subsequent volume patterns should be watched carefully to look for expansion during the advances.
The advance from the low of the head should show an increase in volume and/or better indicator readings, e.g., Chaikin Money Flow (CMF) > 0 or a rise in OBV. After the reaction high forms the second neckline point, the right shoulder's decline should be accompanied by light volume. It's normal to experience profit-taking after an advance. Volume analysis helps distinguish between normal profit-taking and heavy selling pressure. With light volume on the pullback, indicators like CMF and OBV should remain strong. The most important moment for volume occurs on the advance from the low of the right shoulder. For a breakout to be considered valid, there needs to be a volume expansion on the price advance and during the breakout.
Neckline Break. The Head and Shoulders Bottom pattern is incomplete (and the downtrend is not reversed) until the neckline resistance is broken. For a Head and Shoulders Bottom, this must occur convincingly, with an expansion of volume.
Resistance Turned Support. Once resistance is broken, it is common for this same resistance level to turn into support. Often, the price will return to the resistance break and offer a second chance to buy.
Price Target. After breaking neckline resistance, the projected advance is found by measuring the distance from the neckline to the bottom of the head. This distance is then added to the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should also be considered. These factors might include previous resistance levels, Fibonacci retracements, or long-term moving averages.
Alaska Air Group, Inc. (ALK) formed a Head and Shoulders Bottom with a downward-sloping neckline.
Key points include:
The stock began a downtrend in early July and declined from $60 to $26.
The low of the left shoulder formed with a large spike in volume on a sharp down day (red arrows).
The reaction rally at around $42.50 formed the first point of the neckline (1). Volume on the advance was respectable, with many gray bars exceeding the 60-day EMA. (Note: Gray bars denote advancing days, black bars declining days, and the thin red horizontal is the 60-day Exponential Moving Average).
The decline from $42.50 to $26 (head) was quite dramatic, but volume did not get out of hand. CMF was mostly positive when the lows around $26 were forming.
The advance off the low saw a significant volume expansion (green oval) and gap up. The strength behind the move indicated that a significant low had formed.
After the reaction high around $39, the second point of the neckline could be drawn (2).
The decline from $39 to $33 occurred on light volume until the final two days when volume reached its highest point in a month. Even though there are two long black (down) volume bars, these are surrounded by above-average gray (up) volume bars. Also, notice how the trend line resistance near $35 became support around $33.
The advance off the right shoulder's low occurred with above-average volume. CMF was at its highest levels and surpassed +20% shortly after neckline resistance was broken.
After breaking neckline resistance, the stock returned to this newfound support with a successful test of around $35 (green arrow).
AT&T (T) formed a head and shoulders bottom with a flat neckline. The shoulders are a bit shallow, but the neckline and head are well-pronounced.
Key points include:
The stock established a six-month downtrend, with the trend line extending down from March 1998.
After a head fake above the trend line in late June, the stock fell from $66 to $50 with a sharp increase in volume to form the left shoulder.
The rally to $61 met resistance from the trend line, and the high reaction became the neckline's first point.
The decline from $61 to $48 finished with a piercing line pattern to form the head's low. Even though volume was heavy when the long black candlestick formed, the subsequent reversal occurred with even higher volume. This reversal was followed by several strong advances and up gaps. Also notice that CMF was above +10% when the low of the head formed.
The advance from the low of the head broke above the trend line, extending down from March 1998, and met resistance around $61. This reaction high formed the second point of the neckline.
The right shoulder was relatively short and shallow. The low was recorded at $57 and CMF remained above +10% the whole time. Support was found from the trend line that offered resistance a few weeks earlier.
The stock advanced sharply off the lows that formed the right shoulder, and volume increased three straight days (blue arrow). This is a bit early, but volume remained just above average for the neckline breakout a few days later. Also, CMF remained above +10% the entire time.
After neckline resistance break, the stock tested this renewed support twice while consolidating recent gains. The power arrived a few weeks later with a strong move off the support and a massive increase in volume. The stock subsequently advanced from the low $60s to the low $80s.
Head and Shoulder Bottoms are among the most common and reliable reversal formations. It is important to remember that they occur after a downtrend and usually mark a major trend reversal when complete. While it is preferable that the left and right shoulders be symmetrical, it is not an absolute requirement. Shoulders can be of different widths and heights.
Remember that technical analysis is more of an art than a science. Finding the perfect pattern may take a long time.
When analyzing the Head and Shoulders Bottom pattern, focus on correctly identifying neckline resistance and volume patterns, the two most important aspects of a successful read and, by extension, a successful trade. The neckline resistance breakout, combined with an increase in volume, indicates increased demand at higher prices. It means buyers are exerting greater force, which is affecting the price.
As the examples show, traders don't always have to chase a stock after the neckline breakout. Often, but not always, price will return to this new support level and offer a second chance to buy. Measuring the expected length of the advance after the breakout can be helpful, but don't count on it for your ultimate target. As the pattern unfolds, other aspects of the technical picture will likely take precedence. Technical analysis is dynamic, and your analysis should incorporate aspects of the long-, medium- and short-term picture.
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