Completed and potential reverse head-and-shoulders bottom formations are taking center stage in early 2012, writes Tom Aspray, providing examples and in-depth instruction on how to trade these formations.

There are several key chart formations that most successful traders and investors should be able to recognize. Over the years, I have observed that markets go through phases where one formation will be the most common, and then once the majority recognizes this formation, another one starts to dominate.

See related: A Chart Formation the Pros Love

Chart analysis, as I have discussed in previous articles including “How to Get Started in Chart Reading,” is clearly a subjective method of analysis. Of course, as a technical analyst, I would also argue that not only does fundamental analysis lag the price action, but too can be quite subjective.

The rally in the stock market over the past few months was certainly not forecast by the dismal fundamental outlook that dominated in September 2011.

In looking through a large number of charts at the end of 2011, I noticed many stock and ETF charts that had either completed reverse head-and-shoulders bottom formations or appeared be forming them. It was also quite interesting that the stocks were in a wide range of sectors and industry groups.

The reverse head-and-shoulders bottom formation has several well-identified characteristics that allow the investor to clearly determine not only the entry point, but also the stop and profit target.

As is the case in many important chart formations, volume plays a vital role in identifying the formation and in confirming that it has been completed.

First let’s review the basics of the reverse head-and-shoulders (H&S) bottom formation.

Figure 1

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Mylan, Inc. (MYL) is a generic drug maker that peaked in early July at $25 per share and accelerated to the downside in early August. MLY dropped to a low of $17.29 on August 9, forming the left shoulder (LS) before rebounding back to the resistance in the $20.50 area.

MLY stayed between $18.80 and $20.90 for several weeks before the sellers again took over in the latter part of September. Mylan, like many stocks, made a spike low on October 4 when it hit a low of $15.49 before closing the day at $16.16.

A few things were evident at this time, and one was the action of the volume. The volume was quite heavy in August (circle 1), as over 20 million shares were traded on one day. In contrast, the volume was significantly lower in early October when the peak daily volume was ten million shares (circle 2).

This is an important characteristic of a reverse head-and-shoulders bottom formation. Volume should be heaviest at the left shoulder, with lower volume at the head, and even less volume as the right shoulder (RS) is formed.

This volume pattern in MYL suggests that there were fewer sellers in October than there were in August, which was a positive sign. The rebound in MYL from the October lows was quite sharp, taking prices quickly back to $20.52. Once MYL declined from this level, it allowed us to draw a potential neckline (line a), which then became a key level of resistance.  

NEXT: How to Determine Stop Levels and Profit Targets

Tickers Mentioned: ILF, FXI, EWH, MYL, DOV