The Transformative Power of the Inverse Head and Shoulders Pattern in Trading
In the dynamic world of trading, the inverse head and shoulders chart pattern stands as a notable indicator for identifying bullish reversals. Characterized by three distinct troughs: a lower ‘head’ between two higher ‘shoulders’, this pattern signals a potential shift from a bearish to a bullish trend when the price breaks above the ’neckline’.
Traders often enter a position at this breakout point, set stop loss orders below the right shoulder, and use technical analysis indicators such as the moving average, the Relative Strength Index (RSI), and the Moving Average Convergence Divergence (MACD) for additional confirmation. By doing so, they create a multifaceted approach to capitalize on these trading opportunities.
What is the Inverse Head and Shoulders?
The inverse head and shoulders chart pattern is a bullish chart formation that signals a potential reversal of a downtrend. It is the opposite of the head and shoulders chart pattern, which is a bearish formation.
The inverse head and shoulders chart pattern consists of three troughs: the first and third troughs are roughly equal in depth and are known as ‘shoulders’, while the second trough is deeper and is called the ‘head’.
Key Takeaways
- An inverse head and shoulders is similar to the standard head and shoulders pattern, but inverted.
- It may be used to predict reversals in downtrends.
- An inverse head and shoulders pattern, upon completion, signals a bull market.
- Investors typically enter into a long position when the price rises above the resistance of the neckline.
A Detailed Guide to the Inverse Head and Shoulders Chart Pattern
This chart pattern formation is commonly used in technical analysis to predict the reversal of a downtrend. It is a bullish signal that is essentially the reverse of the regular head and shoulders chart pattern, which is a bearish indicator. The structure of the inverse head and shoulders chart pattern is described as follows:
- Left Shoulder: After a downtrend, the price of the respective asset makes a low and then rallies to a higher point, forming the left shoulder.
- Head: Following the formation of the left shoulder, the price declines to a point lower than the left shoulder and then rallies again, forming the head.
- Right Shoulder: Finally, the price declines again but not as low as the previous decline or the head, and then rallies one more time, forming the right shoulder. The right shoulder is typically roughly equal in depth to the left shoulder.
- Neckline: A trendline is drawn connecting the high points (or ‘peaks’) after the formation of each shoulder and the head. This line serves as a level of resistance that the price must break through to confirm the pattern.
Understanding the Psychology Behind the Inverse Head and Shoulders Pattern
The psychology behind the formation of the inverse head and shoulders pattern can be understood through the changing sentiment among traders and investors during its development.
On the left shoulder, the overall sentiment is pessimistic. The sellers are still in control. Then, a minor rally begins to occur as some traders think the security is oversold. However, this rally is short-lived as the dominant sentiment is still bearish.
Next, with the formation of the head of the inverse head and shoulders pattern, the sentiment moves from extremely pessimistic to cautiously optimistic. The price of the respective asset drops even lower than the left shoulder, indicating strong selling pressure. The drop to a new low may trigger panic selling. However, this extreme point often attracts value investors who consider the asset significantly undervalued, leading to a rally.
The right shoulder now begins to form. The sentiment is cautiously optimistic to optimistic. The price declines again but not as low as the head, indicating waning selling pressure. The shallower low suggests that sellers are losing steam and buyers are starting to gain confidence. The sentiment starts to shift from bearish to bullish.
Finally, with the breaking of the neckline, optimism turns into bullishness. The price breaks above the neckline, often on higher volume. The break above the neckline confirms the bullish reversal, leading to more traders who had previously been on the sidelines stepping into the market. This often fuels a strong upward move.
Understanding trader psychology is crucial in technical analysis. Behavioral finance studies suggest that chart patterns like the inverse head and shoulders can be explained by cognitive biases such as herd behavior and the representativeness heuristic.
How to Trade the Inverse Head and Shoulders Chart Pattern
Trading the inverse head and shoulders pattern involves several key steps, each with its own set of considerations. Below is a guideline on how to approach trading this chart pattern:
Identification:
- First Step: The trader should identify the pattern formation on the chart, including a left shoulder, a head, and a right shoulder. Ensure that the pattern follows a downtrend, as there must be a reversal point.
Confirmation:
- Neckline: Draw a trendline connecting the peak of each shoulder and the head.
- Volume: Look for increased trading volume during the breakout above the neckline as a confirmation signal.
Entry:
- Buy Signal: Enter a long position when the price breaks above the neckline, preferably on high volume, or when the price returns to test the neckline.
Risk Management:
- Stop Loss: Place a stop loss order slightly below the right shoulder or the neckline to minimize potential losses.
- Position Sizing: Determine the size of the trade based on risk tolerance and the distance between the entry point and the stop loss.
Profit Target:
- Target Price: Calculate the target price by measuring the vertical distance from the neckline to the lowest point of the head. Add this value to the distance at the breakout point at the neckline.
Exit:
- Take Profit: Exit the position when the price reaches the target level or shows signs of reversing.
- Trailing Stop: Alternatively, use a trailing stop to capture additional gains while protecting the position.
Additional Considerations:
- Confirmation Indicators: Use technical indicators like the RSI or MACD for additional confirmation on the inverse head and shoulders chart pattern.
- Time Frame: The chart pattern is generally more reliable on longer time frames like daily or weekly charts.
An Improved Example of Inverse Head and Shoulders Chart Pattern
On a 15-minute chart spanning July 19th at 11:15 to August 24th at 10:00, the Invesco QQQ Trust Series (QQQ) showcased the inverse head and shoulders chart pattern following an 8.57% decline from a high of $387.98 to a low of $354.76.
The pattern’s left shoulder was marked by lower highs at $365.94 and $363.03, bottoming out at $360.68. The head was distinctly formed at a low of $350.70. Subsequently, the ETF rallied to a high of $362.59, constituting the top of the right shoulder, with a low point at $359.17.
The critical neckline was delineated by highs of $354.76 and $354.70. On August 21st at 13:15, QQQ broke above this neckline, setting a bullish target of $370.66. This target was met with a rally on August 24th at 9:30.
Inverse Head and Shoulders Pattern on QQQ on 15-Minute Chart. TradingView
The Role of Volume in the Inverse Head and Shoulders Pattern
Volume plays a critical role in confirming the validity and strength of an inverse head and shoulders pattern.
During the formation of the left shoulder, volume generally decreases, reflecting waning selling pressure. For the head, volume may spike at the low point as panic selling ensues, but it often picks up again during the subsequent rally, indicating renewed buying interest. For the right shoulder, volume is usually lower compared to the head, signaling that selling pressure is diminishing.
During the breakout of the neckline, a significant increase in volume as the price breaks above the neckline is a strong confirmation signal. It indicates that market participants are in agreement about the asset’s bullish prospects. High volume during the breakout suggests that the upward trend is more likely to be sustained, showing strong buyer commitment.
Why Volume Matters in the Inverse Head and Shoulders Pattern
Volume is essential for several reasons:
- Pattern Confirmation: High volume confirms that the pattern is not a false breakout, increasing the reliability of the trade signal.
- Momentum: A volume-supported breakout often leads to a stronger and more rapid price movement, making it easier to reach the profit target.
- Risk Management: Low volume during a breakout can be a red flag, signaling that the pattern may not be as reliable, aiding in risk assessment.
Volume is often considered an essential second dimension to price in technical analysis. Studies in market microstructure theory suggest that volume contains information about traders’ beliefs and intentions, making it a valuable tool for confirming chart patterns.
The Significance of False Breakouts in the Inverse Head and Shoulders Pattern
False breakouts in the context of the inverse head and shoulders pattern can have significant implications for traders. A false breakout occurs when the price moves above the neckline but quickly reverses, failing to sustain the upward momentum.
Traders who enter long positions based on the initial breakout may incur losses if the breakout turns out to be false. These false breakouts can shake investor confidence and lead to emotional decision-making, such as premature exits or disregarding stop loss levels.
Also, a false breakout may indicate that the asset is not yet ready for a bullish reversal, suggesting that the bearish sentiment still prevails. Moreover, the occurrence of a false breakout often necessitates a re-evaluation of one’s trading strategy, including risk management techniques.
How to Mitigate the Risks of False Breakouts
There are several ways to mitigate the risks of false breakouts in the inverse head and shoulders chart pattern:
- Volume Confirmation: Look for high trading volume during the breakout of the neckline as a confirmation signal.
- Close and Retest: Wait for the price to close above the neckline and even retest it as support before entering a trade.
- Technical Indicators: Employ technical analysis indicators like the RSI or MACD for further confirmation.
- Stop-Loss Orders: Set stop-loss orders to manage downside risk, especially when trading on these types of pattern breakouts.
The Importance of Testing the Neckline
The testing of the neckline in an inverse head and shoulders pattern is crucial and offers valuable insights into the pattern’s reliability and the market’s sentiment on the respective asset.
After breaking above the neckline, the price often retraces back to the neckline level, testing it as new support before resuming the upward trend. A successful retest of the neckline strengthens the validity of the pattern and provides additional confirmation for a bullish reversal.
Also, the retest offers a secondary entry point for traders who missed the initial breakout, often with a tighter stop loss, reducing risk. Another significance of the testing of the neckline is market sentiment. A successful retest indicates that market sentiment on the asset has shifted from bearish to bullish, as the previous resistance level (neckline) now acts as support.
Finally, if the price fails to hold the neckline and falls below it, a false breakout could be signaled, necessitating a strategy re-evaluation.
Setting Profit Targets for the Inverse Head and Shoulders Pattern
The profit targets of the inverse head and shoulders pattern are typically determined using the vertical distance between the neckline and the lowest point of the head. This distance is known as the price objective and serves as guidance for potential upward movement after the breakout.
Profit targets help in assessing the risk-reward ratio of the trade, aiding in decision-making. They provide a logical exit point, reducing the emotional aspect of trading. Moreover, profit targets can be aligned with other trading objectives and strategies, such as trailing stops, to maximize gains.
Combining Inverse Head and Shoulders with Technical Analysis Indicators
Combining the inverse head and shoulders pattern with other technical analysis indicators enhances the reliability of the trading signals. Some commonly used indicators include:
Moving Averages:
- Purpose: To identify the overall trend direction.
- How to Use: A crossover of a short-term moving average over a long-term moving average can confirm a bullish reversal.
RSI:
- Purpose: To gauge overbought or oversold conditions.
- How to Use: An RSI value above 70 may confirm the bullish momentum, especially if it coincides with the neckline breakout.
MACD:
- Purpose: To help identify momentum and trend direction.
- How to Use: A bullish MACD crossover can serve as an additional confirmation signal.
Volume Oscillator:
- Purpose: To help confirm the strength of the trend based on volume.
- How to Use: A rising volume oscillator can confirm the bullish breakout, adding credibility to the pattern.
Fibonacci Retracement:
- Purpose: To help identify potential support and resistance levels.
- How to Use: The 50% or 61.8% retracement levels can act as additional confirmation points or targets.
Bollinger Bands:
- Purpose: To measure volatility and potential reversals.
- How to Use: A price movement that touches the upper Bollinger Band can confirm the bullish trend.
Stochastic Oscillator:
- Purpose: To help identify overbought or oversold conditions.
- How to Use: Generally, a stochastic value above 80 can confirm bullish momentum.
What are Some Technical Analysis Chart Patterns?
Technical analysis employs a variety of chart patterns to analyze price movements and predict future trends. Some reversal patterns include the head and shoulders and inverse head and shoulders, double top and double bottom, and triple top and triple bottom.
Some continuation patterns include flags and pennants, triangles, and rectangles. Also, some momentum patterns include the cup and handle, as well as wedges. Finally, some candlestick chart patterns include the doji, hammer or hanging man, and bullish and bearish engulfing patterns.
What Assets can Use the Inverse Head and Shoulders Chart Pattern?
The inverse head and shoulders chart pattern is a versatile tool applicable to a variety of asset classes. These include equities, commodities, forex, fixed income, ETFs and mutual funds, futures, options, and REITs.
What Timeframe is Best for the Inverse Head and Shoulders Pattern?
The best timeframe largely depends on the trader’s investment objectives.
- Day Traders: May use intraday charts such as the 1-minute, 5-minute, or 15-minute charts.
- Swing Traders: Tend to use hourly charts.
- Position Traders and Long-Term Investors: Focus on daily, weekly, or monthly timeframes.
What are Some Key Technical Analysis Indicators Used with the Inverse Head and Shoulders Pattern?
Some commonly used technical analysis indicators combined with the inverse head and shoulders chart pattern are moving averages, the RSI, the MACD, the volume oscillator, Bollinger Bands, and the stochastic oscillator.
How Reliable is the Inverse Head and Shoulders Pattern?
The reliability of the inverse head and shoulders pattern can vary based on several factors, including the asset being traded, market conditions, and the timeframe used.
The Bottom Line
The inverse head and shoulders pattern is a powerful tool in the arsenal of traders and investors alike. Serving as a bullish reversal indicator, this pattern is characterized by three troughs: a lower ‘head’ flanked by two higher ‘shoulders.’ The pattern is confirmed when the price breaks above the ’neckline,’ signaling a potential change in trend from bearish to bullish. To enhance the reliability of trading signals, traders often combine this pattern with other technical indicators such as moving averages, the MACD, the RSI, and the volume oscillator.
This chart pattern is a comprehensive trading strategy when used correctly. By understanding its structure, applying sound trading rules, and using complementary technical indicators, traders can make more informed decisions, manage risk effectively, and improve their odds of success in the market.
Related Terms: Head and Shoulders, Technical Indicators, Chart Patterns, Volume Confirmation.
References
- Tradingview.com, “Head and Shoulders, Education and Research”
- Stock Market Strategy, “Inverted Head and Shoulders”
- Lo, Andrew W., and Jasmina Hasanhodzic. “The Evolution of Technical Analysis: Financial Prediction from Babylonian Tablets to Bloomberg Terminals”. Wiley, 2010
- O’Hara, Maureen. “Market Microstructure Theory.” Blackwell Publishers, 1995.
- Harris, Larry. “Trading and Exchanges: Market Microstructure for Practitioners”. Oxford University Press, 2003
- Brock, William, Josef Lakonishok, and Blake LeBaron. Simple Technical Trading Rules and the Stochastic Properties of Stock Returns. The Journal of Finance, 1992.
- Murphy, John J. “Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications”. New York Institute of Finance, 1999
