Section 7:

Bullish Reversal Patterns

 

Head and Shoulders Bottom

 

Definition:

A head and shoulders bottom is very similar to a triple bottom. The only difference is that the second rebound from support is at a relatively lower level than the first and third rebounds from support.

A head and shoulders bottom occurs within the context of a bearish trend. It starts when a stock rebounds sharply from a low known as the left shoulder, but then rolls over from a relative high. The pair proceeds to fall to a lower low known as the head before rebounding for a second time to the same high. These two equal highs form horizontal resistance. The pair rolls over once more and falls to the third low known as the right shoulder which is equal to the first low. It rebounds once more to near the relative highs, which are connected to form a horizontal resistance level known as the neckline.

Nuance:

Head and shoulders bottoms are rare, but one of the most popular bullish reversal patterns among traders. They are extremely powerful indicators of a reversal of a downward trend. The patterns are usually very actionable and profitable.

Head and shoulders bottoms sometimes appear diagonally, with a downward or upward sloping neckline, rather than horizontally.

Application:

A head and shoulders bottom is confirmed once the stock breaks above the neckline. An entry can be taken upon the breakout or after waiting for a retest of the neckline, which is a highly effective way of trading head and shoulders bottoms.

Figure 7.5

Example:

Shares of Mobil Telesystems (MBT) traced a head and shoulders bottom after a steady bearish trend as shown in Figure 7.5. The stock first reversed from the $28 level, but found resistance near $32. This first low at $28 was the left shoulder. It fell lower to $26, creating the head of the pattern. MBT traded up to $32 for a second time, but reversed lower for a second time. This reversal created the neckline of the pattern. The stock completed the head and shoulders bottom with a rebound from the $28 level for a second time. This rebound formed the right shoulder. The pattern confirmed when the stock broke above the neckline.

Bullish Reversal Patterns Summary

Bullish reversal patterns predict the end of an existing bearish trend and the beginning of a bullish trend. The patterns can be applied over very short periods of time, especially in the case of 123 bottoms. Other bullish reversal patterns can take months or even years to play.

Reversals such as 123 bottoms and double bottoms are quite common in existing bearish trends, making these particular patterns a little more difficult to trade. Triple bottoms and head and shoulders bottoms are rare, but generally accurate and powerful signals of a pending reversal.

Ultimately bullish reversal patterns go against the prevailing bearish trend, which means traders must be especially careful when managing risk. Furthermore, trading bullish reversal patterns should be reversed for occasional trades when conditions are best for employing such a strategy.

It’s best to trade bullish reversal patterns when the conditions are primed for reversals of bearish trends. Such conditions include old bearish trends, oversold conditions in the broader market or in sectors, extreme levels of pessimism, and divergences in price from other indicators.