Inverse head and shoulders chart pattern for traders

In lesson 3 we looked at the head and shoulders chart pattern. In this lesson, we're flipping that (literally) to focus on the inverse head and shoulders pattern. While it's also used to help spot potential market reversals, this pattern signals the opposite: a potential trend reversal from bearish to bullish. Traders look for it after a downtrend to identify potential buying opportunities.

What is the inverse head and shoulders pattern?

The inverse head and shoulders pattern is the mirror image of the head and shoulders formation. Instead of three peaks, it consists of three troughs, with the middle trough (the "head") being the lowest point, flanked by two higher troughs (the "shoulders"). The market then breaks out above the resistance line (the "neckline"), which connects the two shoulders.

This shows a move to higher lows in conjunction with higher highs – the building blocks of an uptrend. Traders will see this as a signal that a market is transitioning from a downtrend to an uptrend.

Using the same theory of proportion we used with the head and shoulders pattern, we can measure the height from the head to the neckline. We take that distance and project it from the breakout area (where the price moves) through the neckline. We look at that as our potential target.

Traders might use the signal of an inverse head and shoulders pattern to exit short positions or to enter the market and go long.

Using the inverse head and shoulders pattern

Confirm the pattern

The inverse head and shoulders pattern is confirmed when the price breaks above the neckline, signalling a potential uptrend. Spotting it means you first need to identify a downtrend, then the inverse head and shoulders formation, and finally the potential reversal breakout above the neckline resistance.

Key components of the inverse head and shoulders pattern:

1. Left shoulder: the initial trough representing the first phase of the uptrend
2. Head: the lowest trough, surpassing the depth of both shoulders
3. Right shoulder: the third and final trough, similar in depth to the left shoulder but higher than the head
4. Neckline: a resistance line drawn by connecting the highest points between the shoulders and the head

Formation stages of the inverse head and shoulders pattern:

To effectively identify and trade the inverse head and shoulders pattern, it's crucial to understand its formation stages:

1. Downtrend initiation: the market trends downward, creating the left shoulder
2. Pullback to neckline: a temporary rally brings the price back to the neckline
3. Head formation: the price falls again, reaching a new low to form the head
4. Second pullback: another rally brings the price up to the neckline
5. Right shoulder formation: a final decline creates the right shoulder, which forms a low higher than the head
6. Final rally: the price rallies back up, testing the neckline once more

Tip: In a textbook inverse head and shoulders pattern, volume is usually highest as the left shoulder forms, tapers off during head formation, and is lowest during the right shoulder. Importantly, volume often increases during rebounds from the left shoulder to the first peak and from the head to the second peak. This rising volume on upward moves can signal growing buying interest ahead of a potential breakout.

Remember that false breakouts can occur, so it's essential to use additional technical indicators to confirm the validity of the pattern.

Set price targets

Once the pattern is confirmed, traders may set price targets to gauge potential profit opportunities. A common method is the measured move technique:

1. Measure the vertical distance from the head to the neckline
2. Project this distance upward from the breakout point

This projection provides an estimate of how far the price might rally after the pattern completes. However, this is just a guideline – never a guaranteed outcome.

Consider your trading strategy

When trading the inverse head and shoulders pattern, traders might consider the following strategies:

1. Long entry: entering a long position when the price breaks above the neckline with increased volume
2. Stop-loss placement: setting a stop-loss order below the right shoulder to manage risk
3. Target setting: using the measured move technique described earlier to set profit targets
4. Partial profit-taking: consider taking partial profits at predetermined levels to lock in gains

Understand limitations and combine with other technical indicators

While the inverse head and shoulders pattern is a powerful tool, it's not without limitations:

1. Subjectivity: pattern identification can be subjective and may vary among traders
2. False breakouts: the price may briefly break above the neckline before reversing, leading to false signals
3. Reliability: like all technical patterns, the inverse head and shoulders is not 100% reliable

To enhance the reliability of your analysis, consider combining the head and shoulders pattern with other technical indicators:

1. Moving averages: use moving averages to confirm the overall trend direction
2. Relative Strength Index (RSI): look for oversold conditions near the head formation or bullish momentum on breakouts
3. Moving Average Convergence Divergence (MACD): check for bullish divergence during pattern formation

In the next lesson we look at continuation patterns, specifically the symmetrical triangle pattern.