The price action forming both Top and Bottom patterns remains roughly the same, but reversed. The role of marks the biggest difference between the two. Generally speaking, plays a larger role in bottom formations than top formations. While an increase in on the neckline breakout for a Top is welcomed, it is absolutely required for a bottom. We will look at each part of the pattern individually, keeping in mind, and then put the parts together with some examples.
1. Prior Trend: It is important to establish the existence of a prior downtrend for this to be a reversal pattern. Without a prior downtrend to reverse, there cannot be a Bottom formation.
2. Left Shoulder: While in a downtrend, the left shoulder forms a trough that marks a new reaction low in the current trend. After forming this trough, an advance ensues to complete the formation of the left shoulder (1). The high of the decline usually remains below any longer , thus keeping the downtrend intact.
3. Head: From the high of the left shoulder, a decline begins that exceeds the previous low and forms the low point of the head. After making a bottom, the high of the subsequent advance forms the second point of the neckline (2). The high of the advance sometimes breaks a downtrend line, which calls into question the robustness of the downtrend.
4. Right Shoulder: The decline from the high of the head (neckline) begins to form the right shoulder. This low is always higher than the head, and it is usually in line with the low of the left shoulder. While symmetry is preferred, sometimes the shoulders can be out of whack, and the right shoulder will be higher, lower, wider, or narrower. When the advance from the low of the right shoulder breaks the neckline, the Bottom reversal is complete.
5. Neckline: The neckline forms by connecting reaction highs 1 and 2. Reaction High 1 marks the end of the left shoulder and the beginning of the head. Reaction High 2 marks the end of the head and the beginning of the right shoulder. Depending on the relationship between the two reaction highs, the neckline can slope up, slope down, or be horizontal. The slope of the neckline will affect the pattern's degree of bullishness: an upward slope is more than a downward slope.
6. Volume: While plays an important role in the Top, it plays a crucial role in the Bottom. Without the proper expansion of , the validity of any breakout becomes suspect. can be measured as an indicator (OBV, ) or simply by analyzing the absolute levels associated with each peak and trough.
7. Neckline Break: The Bottom pattern is not complete, and the downtrend is not reversed until neckline resistance is broken. For a Bottom, this must occur in a convincing manner, with an expansion of .
8. Resistance Turned Support: Once resistance is broken, it is common for this same to turn into support. Often, the price will return to the resistance break, and offer a second chance to buy.
9. Price Target: After breaking neckline resistance, the projected advance is found by measuring the distance from the neckline to the bottom of the head. This distance is then added to the neckline to reach a price target. Any price target should serve as a rough guide, and other factors should be considered, as well. These factors might include previous resistance levels, Fibonacci retracements or long-term moving averages.