Revenge of the Euro: A Head and Shoulders Bottom

12/19/00 12:52:34 PM

by David Penn

Will the "since-inception" euro bear market end with a H&S bottom?

Security: N/A
Position: N/A

Maybe it's a guy thing. Maybe it's an American thing. Maybe years and years of advancing markets have had some of us scouring the charts in search of tops for so long that we've forgotten what bottoms look like. I don't mean the imagined, hoped-for, longed-for bottoms like the one everyone seems to see, then not see, in the Nasdaq. And I don't mean the bottoms in such woebegone tradables like lumber and silver that still show no signs of hitting the ground (running or otherwise). But a real bottom, one that arrives when everyone is convinced that there is no upside to be found and the only ones left trading are those who must--that's the kind of bottom we're talking about.

Fortunately, we need look no farther than Europe for just such a bottom. Yes, Europe, where the euro--which has been in a bear market virtually since the common currency was developed--appears to finally have sunk as far as it is going to for the time being. And more than just a brief respite in its eternal slide, the euro has worked itself into one of the best formations you can find at the bleak end of a long decline: a head and shoulders bottom.

A head and shoulders bottom looks exactly like a head and shoulders top, only inverted. Whereas the head and shoulders top formation features a series of three, well-defined peaks with the centermost peak tallest among them, a head and shoulders bottom formation consists of three, well-defined troughs with a center trough deeper than the other two. And in the same way that the head and shoulders top formation portends a bearish reversal, so does the head and shoulders bottom formation anticipate a bullish rally.

Three troughs are a charm as the euro's long slide runs right into a head and shoulders bottom formation. The euro could climb as high as 0.925 if the formation is successful.

Graphic provided by: Barcharts.com.

Let's take a closer look at head and shoulders bottoms first, then an even closer look at the way the pattern seems to be developing for the euro from late August 2000 up to the upside breakout in mid-December. A resistance line called the neckline connects the three troughs in the head and shoulders bottom formation. The neckline tends to be horizontal, though there are instances in which the neckline slopes upward or downward somewhat. Volume during the development of the head and shoulders bottom tends to decrease up until the instant of the upside breakout, at which time volume generally (though not necessarily) increases signficantly.

Here, looking at the contract for the March euro, we can first identify the head and two shoulders of the pattern. The left shoulder is formed in September and reaches downward from 0.875 to 0.850. The head of the formation is formed in October. This part of the pattern also begins at 0.875, but extends much deeper, to nearly 0.825. The right shoulder begins in November and is only completed in December, as part of the pattern's upside breakout. The right shoulder is in between the left shoulder and the head in size, starting at 0.875 and reaching just below 0.850. Volume is higher in the left shoulder than in the head, and it is only on the euro's breakout to and above 0.875 that volume returns to its September/left shoulder levels.

What is all the more interesting in this example is how the euro broke through neckline resistance at 0.875 in late November, climbed to an intraday high of 0.9000 and retraced back to 0.875 before resuming its breakout course with a close of 0.9000. This sort of pullback behavior is quite common in many formations, and can be especially prevalent in H&S bottoms, according to Bulkowski (author of "Encyclopedia of Chart Patterns"). Bulkowski also provides a measuring rule for H&S bottoms, one that, in our present example, suggests that the euro could climb as high as 0.925. His measuring rule involves adding the distance from the neckline to the low point in the head trough to the neckline. Here, the 5 cent difference from the neckline at 0.875 to the low point in the head (just above 0.825) added to the neckline gives us 0.925, an area in which the euro has some historic support--mostly in July and May.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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