Head and Shoulders bottom pattern is a decline to a new low and rally to intermediate resistance, a second decline to a lower low and rally to resistance followed by a modest third decline and rally through resistance.
The technical target for a head and shoulders bottom pattern is derived by adding the difference between the neckline and the lowest level achieved in the formation of the "head" to the new breakout level.
As a major reversal pattern, the head and shoulders bottom forms after a downtrend, and its completion marks a change in trend. 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 head and shoulders bottom is sometimes referred to as an inverse head and shoulders.
- Left Shoulder: The reaction high of the decline usually remains below any longer trend line.
- Head: After making a bottom, the high of the subsequent advance forms the second point of the neckline.
- Right Shoulder: This low is always higher than the head and usually in line with the low of the left shoulder. Symmetry is preferred but it is not required.
- Neckline: The neckline forms by connecting reaction highs off of the left shoulder and the head. The neckline can slope up, slope down, or be horizontal. An upward slope is more bullish than downward slope.
- Volume: Volume plays a crucial role. It 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 that in the second half. Volume on the decline of the left shoulder is usually pretty heavy and selling pressure quite intense. The intensity of selling can even 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 and increase in volume and/or better indicator readings (e.g. CMF > 0 or strength in OBV). After the reaction high forms the second neckline point, the right shoulder's decline should be accompanied with light volume. It is 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 an expansion of volume on the advance and during the breakout.
- Neckline Break: Breakout must occur in a convincing manner with an expansion of volume.
- Return to breakout: Often, the price will return to the resistance break (now new support) and offer a second chance to buy.
- Price Target: The distance from the neckline to the low of the head is added to the neckline. Any price target should serve as a rough guide and other factors should be considered as well. These factors might include previous resistance levels, Fibonacci retracements or long-term moving averages