Highlights ①. Gate's "Basic Futures Contracts" course introduces various methods of technical analysis that are commonly employed in futures trading. The aim of these courses is to help traders establish a comprehensive framework for technical analysis. Covered topics include the basics of Candlestick charts, technical patterns, moving averages, trend lines, and the application of technical indicators. ②. This article, as Course V of the series "Master Technical Analysis", will introduce one key candlestick pattern- head and shoulders bottom, and will cover the concept of the pattern, its characteristics, technical meaning, as well as its application in trading.
1. What is the head and shoulders bottom?
The 'head and shoulders bottom' pattern is commonly seen in the late stages of a sharp bullish trend and consists of three distinct troughs. From left to right, these troughs are referred to as the left shoulder, the head, and the right shoulder.
The moving trajectory of BTC price in September 2021 illustrates how the head-and-shoulders bottom pattern forms. Initially, BTC's price experienced a sharp decline, dropping from US$52,000 to US$39,600 in just 3 weeks, representing a cumulative decline of 23%. Afterward, the price oscillated around $39,000, forming the left shoulder, head, and right shoulder in sequence. In its subsequent rebound, the price swiftly broke through the neckline and soared to a peak of $67,000, marking a cumulative increase of over 60% within 3 weeks.
Using simplified candlestick charts, one can easily identify the positions of the left shoulder, head, right shoulder, and neckline - a line connecting the peaks adjacent to the left and right shoulders.
In simplified candlesticks, we can clearly see where the left shoulder, head, and right shoulder are, as well as where the neckline is - a line that connects the peaks beside the left shoulder and right shoulder.
※ Below we summarise the features of the head and shoulders bottom pattern: ①. This pattern typically emerges after the market undergoes a significant decline, with the bullish trend initially progressing at an astonishing pace.
②. The head and shoulders bottom pattern often forms during the later stages of this decline. It is characterized by three troughs in the period's candlestick chart. The left and right troughs are roughly at the same height and are termed [the left shoulder] and [the right shoulder], respectively. The central trough, which is the deepest of the three, is referred to as [the head].
③. By connecting the two peaks achieved during price rebounds, one can define the [neckline]. Once the price moves past the second shoulder and rises to breach this neckline, the head and shoulders bottom is confirmed.
④. A neckline break is only considered legitimate if it is accompanied by a significant increase in trading volume. Without this, it may be a false breakout.
Once you grasp the characteristics of the head and shoulders bottom pattern, the next step is to ascertain the buy and sell points based on this pattern.
Primarily, the neckline serves as a demarcation between bullish and bearish markets. When the price surpasses the neckline, it indicates a dominant buying force. This presents an opportunity for asset acquisition rather than selling. Conversely, if the price descends below the neckline, it signals a stronger inclination among traders to offload their assets. In such cases, traders should align with the trend and consider selling positions.
①.First buying opportunity: when the price breaks up the neckline
Once the head and shoulders bottom pattern is confirmed, the initial buy signal emerges as the candlestick rebounds to breach the neckline, depicted by the green line in the figure below. This break above the neckline represents a definitive bullish signal, suggesting a strong likelihood of a bullish market ahead.
②. 2. Second buying opportunity: the price falls to a point above the neckline after breaking it up.
Once the price breaks above the neckline, it often retreats slightly above the neckline before ascending again. This subsequent rise serves as another signal to open long positions. This dip-and-climb movement following the initial neckline break is termed "neckline confirmation."
③.Third buying opportunity: the price runs higher than the previous high
The third buying point arises during the continued ascent of the price after the formation of the head and shoulders bottom pattern. Specifically, when the rising price surpasses the previous high and a green candle forms above the neckline on that same day, it signals a buying opportunity.
※ Summary of Features and Application of the Head and Shoulders Bottom Pattern
The pattern's structure consists of the left shoulder, the head, and the right shoulder. Additionally, there's a neckline, serving as the boundary between bullish and bearish markets.
From the head and shoulders bottom pattern, we identify three buying opportunities: ①. When the candlestick breaks above the neckline. ②. After the candlestick has broken above the neckline and then retraces slightly above it before rebounding. ③. When the candlestick exceeds the previous high.
2. Compound head and shoulders bottom pattern
The above provides an overview of the standard form of the head and shoulders bottom pattern. However, in actual trading, the pattern often manifests in varied forms. One notable variant is the compound head and shoulders bottom pattern. While it deviates from the traditional head and shoulders bottom pattern, it carries the same technical implication, signaling an imminent trend reversal.
When the pattern emerges at the bottom, it suggests the downward trend is nearing its conclusion and a rebound is on the horizon.
Conversely, when it materializes at the top, it signifies the end of a bullish trend, paving the way for a subsequent downtrend.
While the head and shoulders bottom is a trustworthy signal for a market reversal, pointing to a strong potential for a bullish trend, it merely indicates a likelihood, not a certainty. The market's dynamic nature means outcomes can sometimes deviate from expectations. For instance, even if a head and shoulders bottom pattern has formed, there may be situations, like the one highlighted below, where it's prudent to decisively close positions and exit.
After the head and shoulders bottom pattern materializes, the price often meets resistance during its ascent. As depicted in the figure, it descends below the neckline, accompanied by a red candle that day which breaches the neckline. This pattern suggests a strong likelihood of a steep drop.
While the price may rally briefly, it tends to decline rapidly again, often before reapproaching the neckline. This is a prime selling point; otherwise, one risks being caught in the looming downturn.
Savvy investors not only maximize gains by selling assets at the optimal moment but also discern the ideal exit point when assets depreciate. This strategy enables them to contain losses within an acceptable threshold.
3. Summary
The head and shoulders bottom pattern is generally regarded as a reliable signal for trend reversal: the current downward trend is drawing to its end, and a bullish market will ensue soon. After the pattern is established, the breaking of the neckline by the rising price provides an important buying signal.
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Disclaimer This article is for informational purposes only and does not constitute investment advice. Gate is not responsible for any investment decisions you make. Content related to technical analysis, market assessments, trading skills, and traders' insights should not be considered a basis for investment. Investing carries potential risks and uncertainties. This article offers no guarantees or assurances of returns on any type of investment.
