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Saturday, May 22, 2010

HEAD AND SHOULDERS BOTTOM PATTERN – Part 1: Formation

Head & Shoulders Bottom Pattern is a bullish reversal pattern that normally forms after an extended downtrend, which marks a shift in trend from bearish to bullish. This pattern is very popular because it is regarded as one of the most reliable of all patterns.
Head and Shoulders Bottom pattern is sometimes referred to as Inverse Head and Shoulders pattern.

The Formation of Head and Shoulders Bottom Pattern



Head and Shoulders Bottom Pattern contains three consecutive, sharp bottoms, whereby the middle bottom is the lowest (Head) and the other two bottoms (left & right bottoms) are higher & roughly equal in size (Left & Right Shoulders).

This pattern forms when the price is in an existing downtrend. The price falls and hits a low then bounce up (forming the Left Shoulder). Afterwards, the price falls to an even lower low and then bounces up again (forming the Head). The Right Shoulder is formed when the price drops again but it does not reach the low of the Head. Instead, the price bounces back up after it has hit about the same price level as the Left Shoulder.
Although the Left & Right Shoulders do not necessarily need to be exactly the same, but it should appear roughly equal to one another.

The important part of this pattern is the Neckline. The Neckline is formed by drawing a line that connects two high points: (1) the high point in between the Left Shoulder & Head, and (2) the high point in between the Head & Right Shoulder.
This Neckline can be horizontal, sloping upwards or downwards.

The pattern is only completed and confirmed when the price increases and closes above the Neckline, which serves as the key resistance level in this pattern.

Although Head & Shoulders Bottom is viewed as a common pattern and quite easy to identify, it’s actually not the case. Therefore, one should pay close attention & take proper steps to analyze the characteristics of Head & Shoulders Bottom in order to minimize / avoid making mistakes in spotting the pattern.
The characteristics of the pattern will be discussed in more detail in the next post.

To be continued to Part 2: Important Characteristics of Head & Shoulders Bottom pattern.

To find out more about other Chart Patterns, please refer to:
Learning Charts Patterns

Analysis Tool:
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Related Topics:
* Learning Candlestick Charts
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Option Greek
* Understanding Implied Volatility (IV)
* Understanding Option’s Time Value

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