Novice Traders’ Notebook
Cardinal Reversal Patterns — At Bottoms
2. The Head-and-Shoulders Bottom
In a downtrend, the price action will be a series of lower highs succeeded by a series of lower lows. With each dip into new lows, the volume will expand, indicating that the lower prices are attracting new sellers (A). During the retracement that follows, the rallies will show light volume, evidence of a dearth of new buyers (B). The left shoulder and the head of this reversal pattern, called a head and shoulders bottom, will have this volume sequence of higher volume as the price falls and light volume during the rally between the left shoulder and head. During this process, the news accompanying the declines will be bearish, giving traders the confidence to continue to push the market down. Often, the rallies will be driven only by short sellers’ profit-taking. After the head forms, the market will rally to approximately the same price level as between the left shoulder and head. As sellers sense the rally has run its course, the market will begin to decline, with more new lows are on the horizon. At this point a trendline, known as the neckline (C), can be drawn along the two peaks. As the market falls, the volume may expand due to one last gasp of panic selling, which in turn is quickly reversed (D).
On the other hand, if the volume does not increase, then this lack of volume points to a situation in which sellers are unable to attract a following due to a change in the fundamentals. In this instance, the price action is indicating that there is an upcoming turn in the trend. The smart money was more than likely buying as the head was developing. As the right shoulder is forming, the well-informed money is buying in anticipation of the news turning bullish.
At this point, the market begins to advance, rallying to the neckline. A short-term consolidation often occurs just under the neckline. Next, the market breaks out to the upside with heavy volume (E) and usually with very bullish news. After a few days of consolidation and often a retest of the neckline, the uptrend is under way. It is important that the breakout of the trendline is accompanied with an increase in volume, indicating that large players are confident about the upward trend.