Stock Trading Strategies > Technical Analysis > Chart Patterns

Head and Shoulders Bottom Chart Pattern

Technically speaking, a head and shoulder 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

Why Does It Happen?

Head and shoulders patterns are among the most important of reversal patterns because they are both common and reliable. The head and shoulders bottom pattern consists of three declines and a breakout. This reversal pattern, sometimes called the inverted head and shoulders pattern, gets its name because it is the inverse of the head and shoulders top pattern. The "left shoulder" of a head and shoulders bottom pattern will always take shape after an extended decline to new lows. Against the backdrop of increasing unfavorable fundamental developments the stock sinks to one low after another, investors become decidedly bearish.

The first phase of the head and shoulders bottom pattern is usually the product of a particularly negative fundamental development. Although the stock is already well off its recent highs, this new negative development seems to be beyond the scope of most investors. The stock immediately sinks to a new low on very strong volume. Despite the bad news, the decline is short-lived because serious longer-term investors begin to establish positions. Just days later the imbalance between buyers and sellers leads to a brisk rally to an intermediate term resistance level. Technicians call this rally the reaction high because it is a reaction to the initial decline to new lows. This price action also completes the left shoulder of the pattern. Because all of the fundamental news remains bearish, investors and analysts rationalize that the stock had simply fallen too far and days later the decline resumes.

The stock falls to a new low but volume is substantially diminished, selling pressures are drying-up. The weak volume on the decline and the new lower prices encourages buyers, very soon a new rally develops and the stock once again moves toward the reaction high (overhead resistance level). This price action completes the head of the pattern. Once again sellers return amid poor fundamental news. This may be a negative corporate development or an analyst downgrade but the stock starts to drift lower for a third time. As price falters, volume diminishes substantially again and buyers reassert themselves, forcing a rally back to the overhead resistance level. This price action completes the third a final phase of the pattern, the right shoulder. The negative comments from Wall Street analysts continue but this time buyers overwhelm sellers and the stock surges through resistance. Weeks later the stock rallies to longer-term resistance.

How are Technical Targets Derived?

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.

Head and Shoulders Bottom for Federal National Mortgage

Although Federal National Mortgage (FNM) has been one of the few consistently profitable government sponsored enterprises in the Spring of 2000 the firm was at the center of firestorm of controversy. Richard Baker, reform-minded Republican from Louisiana tabled legislation that would have seen the firms ability to raise and lend money severely curtailed. The initial reaction was one of disbelief, investors assumed that such legislation would never really pass because the Clinton administration had expressed opposition to the bill and there did not seem to be the will among Republicans to force the issue. In June of 2000 that all changed when presidential candidate George W. Bush showed an interest in re-examining the issue if he was elected president in the upcoming election.

Amid poll results and more wrangling on Capitol Hill, Federal National Mortgage stock tumbled to a relative new low at $51.30 on June 30. Volume was extremely high as all signs pointed to the fact that Federal National Mortgage would face a tough time under a Bush administration. However, by July 11 cooler heads prevailed and the stock had recovered to $58.93 (reaction high and completion of left shoulder). Just one day later Federal National was on the move lower again. Current monetary policy added to the legislative woes as the Federal Reserve continued to raise short-term interest rates to quell potential inflationary pressures. By April 3 the stock had sank all the way to $48.13, another new low on lower volume. Once again buyers returned and the stock began to move higher, reaching the old reaction high at $59.00 by August 22.

This move higher completed the head of the pattern but it also energized sellers. On September the stock fell back to $52 in weak trade only to surge a third time to the resistance level at $59 on news that legislative efforts to thwart Federal National Mortgage had hit a roadblock as lawmakers broke for the November elections. This time the stock soared through resistance at $59 and pushed to greater than $88 just four months later.

Vital Signs

Symmetry is Important. The most reliable head and shoulders top patterns are symmetrical, that is the left and right shoulders take shape over roughly the same number of days. Patterns with extended right shoulders should be avoided.
It is important that volume decline on each successive phase of the head and shoulders bottom pattern and surge on the break above the neckline. The weak volume and declining price is a good indication that accumulation is at work.
No pattern is truly complete until there is a breakout close above the neckline of the pattern.
Upside breakouts often lead to small 2-3% rallies followed by an immediate test of the breakout level. If the stock closes below this level (now support) for any reason the pattern becomes invalid.

Now let's examine the inverse of the head and shoulders bottom, the head and shoulder's top.

broadening top head and shoulders top