THE HEAD AND SHOULDERS BOTTOM

In last week's "Inside the Black Box" section of this newsletter I discussed at length the triple bottom pattern created by the S&P 500 when it closed above 965. In doing so, I noted that the triple bottom is a major REVERSAL pattern -- that is, a price pattern that marked a highly significant, long-term change in trend from down to up.

The importance of the reversal pattern, it was noted, could be judged by three factors: the amount of time it took to form, the height or point range of the pattern during construction, and the amount of shares that changed hands while it was forming. Because the S&P 500 bottom formed over nearly one year, covered 200 points in construction and involved volume of billions and billions of shares, it is a highly significant pattern.

Since the S&P 500 describes the market as a whole, but not any one particular stock, as swing traders one way to spot excellent trading opportunities is to look for stocks that have also formed major reversal formations. Such formations can take a variety of shapes, such as ascending triangles, saucer bottoms or inverted head and shoulders. Recognizing and acting on these patterns can lead to healthy swing trading profits.

The price pattern I'm going to cover this week is called the "head and shoulders" bottom, or inverted head and shoulders. It is the opposite of the head and shoulders top, which often marks important reversals to the downside.

The head and shoulders pattern is difficult to visualize. I describe it below, but you may want to take a peak ahead to the weekly chart of Gap Stores (GPS, $16.82), which illustrates the pattern quite well.

There are four parts to the inverted head and shoulders bottom. First, a stock must go through a period of extensive (and often sharp) decline. After a selling climax, the stock rallies slightly and after the rally often drifts sideways. This is the "left shoulder."

After a period of sideways consolidation, the stock breaks below the support level of the left shoulder and trades to a new low. This new low is often made on lower volume than was seen at the bottom of the left shoulder. A rally then takes the stock back to resistance at the top of the left shoulder. This part of the pattern is called the "head."

The third part of this pattern again involves a selloff from the resistance level. This decline is often marked by reasonably low volume. The decline must stop above the level of the head. This is called the "right shoulder."

After the right shoulder is formed, a rally starts. The rally pushes through the resistance level at the top of the left shoulder and head. This resistance level is termed the "neckline." As with other breakouts from consolidation, the penetration of resistance should be accompanied by much higher-than-normal volume. If you do not see very strong relative volume on the breakout, then the power of that breakout is questionable.

The measuring principle can be applied to the head and shoulders bottom. To derive a price target for the move after the breakout, count the amount of points from the bottom of the head to the neckline. Add these points to the breakout level and you should arrive at the eventual level the stock will likely reach.

I identified Gap Inc. in our "Stocks to Watch" section above as an issue that should be closely tracked. It appears to have formed an inverted head and shoulders bottom.

Between late 1999 and early 2000, GPS formed a double top formation at just over $50. As the market weakened, so did GPS. As the chart above starts, the shares had traded down from $30 in just a few short weeks. A final exhaustion gap marked the end of the decline at $11.04 and the beginning of the left shoulder.

Over the next several months, GPS rallied back to the $17 level, where it stalled twice. A renewed downtrend starting in May 2002 took the company below the support level lows of $11 down to a new bottom at $8.35 in September 2002. From here prices rallied sharply to $16.75 in January 2003. Again, the stock hit resistance right around $17. This is the top of the head. A neckline could now be drawn above the tops of the left shoulder and the head.

The final phase of the pattern was formed with the multi-week decline to $12.01, very close to the bottom of the previous left shoulder, and then the recovery to the highs near $17. This part of the pattern is the right shoulder.

Finally, GPS broke out above $17. The week it broke out it traded more than 2.5X its normal volume; this substantially higher-than-normal volume is a requirement of a genuine head and shoulders breakout.

Since the breakout, the shares have consolidated in a narrow range. They are now testing the neckline. Since old resistance should equal new support, buying Gap here should be a low-risk entry point for the intermediate- or longer-term trader. Risk here is very low since the stock should find support near the breakout and certainly no lower than the rising 30-week moving average, which is also close by.

Swing traders, however, would want to time their trade more exactly. One strategy would be to acquire the stock at support, which looks very solid at $16. Another tactic would be to buy GPS as it begins to "move" -- perhaps on the first close above $18.10, which would be a break through the current consolidation. I have placed this stock on our "Watch List" and I will be monitoring it closely for an opportunity to enter.

Since GPS created its head and shoulders bottom over almost two years, and billions of shares were traded in the construction of this pattern, the inverted head and shoulders seems highly significant. Using the measuring principle, we can take the low of the pattern at $8.35 and the high of the pattern at $17.11 to find an eventual target. This amount is $8.76 + $17.11, giving us a price objective of $25.86. Remember this is the minimum objective, but GPS will take time to hit that target.

Swing traders should be on the lookout for other stocks that are forming an inverted head and shoulders pattern. The ability to accurately spot this formation could put you... well... head and shoulders above other swing traders!

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