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

The overall stock market formed a short-term peak in the latter part of October and declined until Black Friday, November 25. MYL made a low of $17.22 on November 22 (RS), which was just above the October 20 low of $17.02. This was also quite close to the August low. In a classic reverse head-and-shoulders bottom, the left and right shoulders are at approximately the same levels.

To complete a reverse head-and-shoulders bottom formation, MYL needs to close back above the neckline, ideally on good volume.

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The neckline was challenged in the early part of December, but it was not decisively broken on a closing basis until December 12. With this close, the reverse head-and-shoulders bottom formation was completed.

In order to determine the targets from a reverse head-and-shoulders formation, we take the distance from the low when the head was formed ($15.49) and subtract it from where the neckline was ($20.69) as MLY was making its low. This difference, ($20.69 - $15.49) $5.20, is then added to the breakout level of $20.22 to give you an approximate upside target of $25.42. This target can be then be used to measure the potential reward of the trade.

Once the neckline is broken on a closing basis, the strategy is to buy on a retest of the neckline or even a bit below it. In the case of MYL, it dropped as low as $19.88 before turning higher. The traditional place for a stop is under the RS low of $17.22. I would typically suggest using a stop that was 0.5% below this level, which would have been $17.04.

The risk of over $3 per share initially may have been too high for most, and I usually determine the stop on a case-by-case basis or just use an initial stop under the RS. Generally, once a reverse head-and-shoulders bottom is completed, it should move well above the neckline within the next week or so.  

Once the December 12 high at $20.65 was overcome, a stop under the prior low at $19.31 could have been used. If MYL dropped back below that low, it would suggest that the breakout was false.

In terms of managing this trade, I typically look at other factors in addition to the head-and-shoulders target to determine an exit level. The chart of MYL shows major trend line resistance, line a, in the $23.80 area. Therefore, selling half the position below this level—like between $23.52 and $23.68—would be prudent in order to lock in a good profit.

Additionally, when MYL moved above the $22 level, the open position would have had a near-9% gain, so a stop under $20.50 could have been used to lock in a small profit.

I find the on-balance volume (OBV) to be very helpful in identifying reverse H&S bottom formations, and the on-balance volume for MYL moved through the resistance at line b seven days before the neckline was broken.

NEXT: A Reverse H&S Bottom Nearing Completion

Dover Corporation (DOV) is an $11 billion industrial company that currently yields 2.2%. DOV made it made its high for 2011 in July at $70.15 before dropping 28% to low just above $50 in early August. Nine days later, these lows were slightly broken when DOV made a marginal new low at $49.91. The rally from these lows stalled at $58.81 before the selling resumed in September.

On October 4, DOV hit a low of $43.64 but closed the day at $47.48, which was a pretty impressive reversal. Volume in October was lower than in August and declined further as the October lows were forming, line d.

Figure 2

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DOV peaked at $58.89 in late October before again dropping back to the $50 level just before Thanksgiving. This has been labeled as the right shoulder (RS) of a potential reverse head-and-shoulders bottom formation. The volume spiked on November 28 after the right shoulder low, which was a positive sign.

In order to complete the reverse head-and-shoulders bottom formation, DOV needs a decisive close above the neckline, which is currently just above $60.

The potential upside target if this reverse H&S bottom formation is completed is roughly at $75.51. This is calculated by taking the difference between the neckline when the head was being formed at $50.14 and subtracting $43.64 from it. This gives a difference of $15.50, which is added to the breakout level at $60.01 to get the upside target.  

It is also important to note that the chart resistance connecting the February and July highs is currently at $73.80, which could also be a significant barrier.

So how can we trade this? With a $60 stock, I would look for close well above the neckline—let’s say at $60.60—to confirm the reverse head-and-shoulders bottom formation. I would then be looking to buy roughly between $59.90 and $60.25 with a stop under $54.67, which was the December 14 low.

If this position is established, I would look to raise the stop to breakeven on a move above $65 and sell half the position at $73.34 or better. If half of the position is sold, raise the stop further to $60.80 on the remaining position.

A drop below $55 per share would be the first sign that this was not a reverse head-and-shoulders bottom formation. A decline below the right shoulder (RS) level of $50 29 would be negative.

NEXT: Equity Fund Exhibits Classic Reverse H&S Bottom

This chart is of Gabelli Dividend and Income Trust (GDV), which is a closed-end equity fund that has a current value of $1.3 billion and yields 6.1%. The neckline at $15.24 (line b) was overcome on December 23, and since then, the fund has traded as low as $15.10, testing the neckline several times.

GDV has been strong this week, closing Wednesday, January 11 at $15.75. The daily chart again shows a completed reverse H&S bottom formation.

Figure 3

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The fund made a high in early July at $17.19 and formed its initial low, the left shoulder (LS) at $13.45, on August 8. Volume was very heavy on this decline, and it peaked on August 5, suggesting that the majority of the weak longs sold on this drop.

GDV rallied back to a high of $15.42, which was just above the 50% Fibonacci retracement resistance level. The increased concerns over the Eurozone debt problems put additional pressure on GDV, as it dropped to a low on October 4 of $12.32, but as was the case with DOV, it rebounded to close well off the highs at $13.08.

Volume on this decline was well below the levels seen in August, suggesting that fewer sellers were pushing prices lower.

The rally from the October lows eventually reached a high of $15.32 on October 27, which was just below the August 30 high of $15.42. The resulting decline ended on November 22 when GDV had a low of $13.82 (RS). This was above the left shoulder level of $13.43.

The OBV confirmed the positive volume pattern, as it moved through resistance at line d five days after the lows. The downtrend from the summer’s highs, line c, was broken in early November. The OBV shows a nice uptrend from the lows and has confirmed the recent price action.

Now that the neckline has been broken, I hope you are able to calculate the upside target using the data provided on the chart. I have added the price levels for both the October low and where the neckline was when this low was being formed. The breakout level was at $15.25, so take a moment now to calculate the potential upside target from this reverse H&S bottom formation.

I hope you have come up with a target of $18.30 from this formation. Remember that this is an approximate target. Before this level can be reached, however, GDV has to surpass the significant resistance from early 2011, line a, which is now in the $17.30 area.

It is probably too late to get into GDV now, but due to the attractive yield of over 6%, I would look to buy at $15.28 or better using a stop at $14.14. If filled, raise the stop further to $14.88 on a move above $16.46 and sell half the position at $17.20.

NEXT: Weekly Charts Can Tell a Whole New Story

As regular readers know, I always advocate looking at both daily and weekly charts because the weekly charts often give a much different perspective. This can be especially true when it comes to observing reverse H&S bottom formations on the daily charts.

The weekly chart of the iShares S&P Latin America 40 Index Fund (ILF) shows that the on-balance volume completed a top formation in June, as it formed a negative divergence, line c, that was confirmed by the break of support (line d).

Figure 4

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The formation on the weekly chart, lines a and b, shows what appears to be a flag formation, which is typically a continuation pattern or an interruption in the overall trend. If this formation were completed, it would project a drop below the August lows.

At this time, this is still a valid interpretation, but the action of the on-balance volume does allow for a more bullish interpretation. The OBV shows a nice uptrend from the lows and has moved well above its rising weighted moving average (WMA).

An examination of the daily chart shows a potential reverse H&S bottom formation with the neckline (line e) currently at $46.

The LS low in August was at $40.43, and after bouncing to a high of $47.92 at the start of September, ILF made a sharply lower low in October at $36.73. On October 28, the rebound in ILF peaked at $47.05 and then dropped to a low of $39.92, forming a potential right shoulder (RS?).

The daily OBV pattern also supports the case for a reverse H&S bottom. The downtrend from the April highs, line f, was broken at the end of October. The OBV shows a clear pattern of higher highs with support at line g.

Because of the sloping neckline (line e), the October high at $47.05 is also a significant level of resistance. On a decisive close above $46, the upside target for the reverse H&S bottom formation would be at $56.70. But from the weekly chart, it should also be noted that the major 61.8% Fibonacci retracement resistance level is at $48.27.

Because this is a rather volatile ETF, I would look to buy at $46.12 only after two consecutive daily closes above $46.50 or better and use an initial stop at $41.44. On a move above $48.10, raise the stop to $45.86 and sell half the position at $51.60 or better.

Several other emerging market ETFs including the iShares FTSE China 25 Index Fund (FXI) and the iShares MSCI Hong Kong Index Fund (EWH) also show potential reverse H&S bottom formations that have not yet been completed (see “3 Asian ETFs to Watch”).

NEXT: Revisit Key Points for Trading This Formation

As was evident from my weekly chart analysis of ILF, what appears to be a reverse head-and-shoulders bottom formation on the daily chart can look like a flag formation on a weekly chart. That is why it is generally not a good idea to anticipate the completion of a reverse H&S bottom formation unless you have strong technical evidence from the on-balance volume or the RS analysis.

Pengrowth Energy Corp. (PGH) is a high-yielding (7.6%) oil and gas company. The daily chart shows what still may be a reverse head-and-shoulders bottom formation. However, last week, it failed to surpass the neckline, line b, and has now violated short-term support at line d.

Figure 5

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The pattern of the OBV is not encouraging either, as it is still locked in a trading range, lines f and g. A break through resistance is needed to turn the outlook to bullish.

There are several ways to draw the neckline because of the twin highs in August and early September, but I think that line b is the most valid. It could also be drawn connecting the late-August and late-October highs (line c). This neckline was overcome in early December. The 50% retracement resistance at $11.30 also made me select line b as the more significant level.

No matter which neckline is used, a drop below the support at $10, line e, would weaken the pattern, and a break below the RS at $9.37 would indicate that this is not a reverse H&S bottom formation. If the neckline (line b) is overcome, the upside target from the reverse H&S bottom formation is in the $14.80 area.

There are quite a few more current examples I could’ve used in this article, including the chart of Southern Copper (SCCO), which I discussed here, and the regional banks I covered earlier in the week.

I would suggest that you go to any of the popular charting sites, and I hope you will now be able to identify quite a few completed and several potential reverse H&S bottom formations.

Before you take trades based on your findings, however, analyze the volume closely, especially the on-balance volume. Once the neckline is broken, try to buy on a retest of the neckline level. In advance of your buy order, you should calculate the potential target from the formation and where you will place your stop. Only then will you be able to determine whether the risk is worth the potential reward.

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