Head and Shoulders Bottom explained

The following characteristics must be present for a Head and Shoulders Bottom pattern to be valid.

Head and Shoulders Bottom classic pattern

  1. A stock must be in a significant down-trend before the beginning of the formation. This makes sense since the Head and Shoulders Bottom is a trend reversal pattern.
  2. The left shoulder is formed when prices move up from the first low in the chart pattern, as shown in the figure above.
  3. Following the first rally which formed the left shoulder, the price then moves to a new low (note this low must be lower than the left shoulder). This point represents the head.
  4. A subsequent rally then begins up to a point near where the first rally ended. In the diagram above, this is shown as a rally up to the exact point of the first rally. In practice, this is rarely the case. The rally from the head position often stops below or carries on above the first rally.
  5. A small corrective fall in prices forms the right shoulder. It is at this point that the neckline can also be drawn which connects the top of the left shoulder with the top of the right as shown in the diagram above.
  6. You should only purchase (go long) once the price breaks the neckline. It is important to wait until the neckline is significantly broken before placing the trade.

Head and Shoulder Bottom examples in the FX Market

Towards the end of 2008, the NZD/USD weekly chart showed signs of reversing the significant downtrend that had prevailed throughout most of the year, which saw the cross currency drop from a high of around $0.82 to below $0.55 by the end of 2008. Astute traders would have noticed the significant rally in the NZD/USD around December 2008. The rally saw the NZD/USD move up from the low of approximately $0.53 to $0.59 which marked the formation of the left shoulder. In early, 2009 this rally was followed by a sharp decline which saw the cross currency fall back to approximately $0.50 cents (which is marked as the head). The subsequent rally back towards $0.59 showed further evidence of a Head and Shoulders bottom forming. Once the cross currency had dropped back to approximately $0.55 around May of 2009 a neckline had formed. The sophisticated investor would have gone long on the NZD/USD when it rallied above $0.59 in July 2009. The penetration of the neckline on the upside was an extremely bullish sign that a trend reversal was taking place. The NZD/USD subsequently rallied from $0.59 to $0.75 over the next 3 to 4 months resulting in a 27% profit.

Head and Shoulders Bottom FX market

The important thing to note about this chart is that the pattern formed over 10 months. It is often the case that Head and Shoulders Bottoms form over a significantly long period. Monitor these chart patterns closely as they are very profitable, but don’t jump the gun and get in too quickly. Make sure that the neckline is significantly and clearly breached before you jump in.

Published on 12th of April 2011
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