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Head
& Shoulders Bottom
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
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