Inverse Head and Shoulders Pattern
The inverse head and shoulder pattern is the opposite of the standard head and shoulder pattern as it indicates a bullish reversal. The pattern is also called Head and Shoulder Bottom and unlike the standard head and shoulder pattern that is comprised of three troughs that are followed by an advance. The pattern forms in a downtrend that is why its shape is inverse to the standard head and shoulder pattern.
In the pattern, the middle trough is the deepest and is called the head. The troughs on the left and right of the head are called the left and right shoulder. Both shoulders remain above the peak of the head. The advance from the troughs is connected using a trend line and is called the neckline. The neckline act as a resistance line and the pattern is confirmed when the advance from the third peak breaks above the neckline.
Pattern Anatomy
The inverse head and shoulder pattern is an equally strong reversal pattern. The pattern indicates the struggle between the bullish and bearish forces who attempt to take the control of the market. In a nutshell, the pattern indicates a rising demand or the declining supply towards the end of a downtrend which causes the price to rise in the coming session.
The inverse head and shoulder pattern is a reversal pattern therefore the pattern is only valid if it is formed in a downtrend. For a reliable signal, the downtrend should be in place from a few weeks to a couple of months.
The left shoulder is the first trough in the pattern and the advance from the left shoulder should be at least 10 to %15 of the total decline of the downtrend.
The head is formed when the price falls from the high of the left shoulder and drops below its low. The second trough (head) must be lower than the low of the left shoulder.
The right shoulder is formed when the price drops from the high of the head. The low of the right shoulder should remain above the low of the head but remains in line with the low of the left shoulder.
The neckline is formed by connecting the highs of the left and right shoulder. Ideally but not always the highs should be consistent. It is also normal for the neckline to slightly slope up or slope down. A slope up neckline indicates a stronger bullish momentum compared to a slope down the neckline.
A signal from the inverse head and shoulder reversal pattern is only confirmed when the advance from the right shoulder extends above the neckline. If it does not extend above the neckline the ongoing downtrend may resume anytime.
The neckline in the pattern acts as a resistance level. However, after the price breaks above the neckline, its role is reversed and it acts as a support line.
Once the neckline is breached, the distance between the neckline and the peak of the head can be measured to determine the take profit.
Using The Pattern
The inverse head shoulder pattern is a common reversal pattern and it indicates a major trend reversal. However, traders need to correctly identify the pattern to avoid making substantial losses. Like the standard head and shoulder pattern, the identification of the neckline in the inverse head shoulder pattern is also the key factor because it confirms the final signal. The volume is also a deciding factor in this pattern that traders should never ignore. A divergence between the volume and the price movement can well be an indication of a fake-out.
The following chart of EUR/CAD is an excellent example of the inverse head and shoulder pattern. The pair had been in a downtrend from 1.5000 until some correction around 1.3300 create the left shoulder of the pattern. Following a moderate correction, the pair once again resumed the downtrend and moved below the left shoulder. However, the bears couldn’t sustain and the price once again moved up towards the high of the left shoulder. The second higher move created the head of the pattern. The bears then made a third attempt to take the price lower. This time they failed badly and the price even remained above the low of the head. This created the right shoulder and the neckline is created by connecting the highs of the right and left shoulder. The price then advanced for the third time and finally breached above the neckline that completed the pattern and indicated a bullish reversal. Following the signal, you can see the pair went further higher towards 1.51000.
Trade Setup Using Inverse Head & Shoulders Pattern
The inverse head and shoulders pattern indicates a major trend reversal and requires a proper trade setup to fully benefit from it. Since it is a bullish reversal pattern an ideal point to enter a buy trade is when the neckline is breached. Remember once the neckline is breached it acts as a support line. To minimize the risk, traders can place the buy entry once the neckline line is tested a few times.
In this trade setup, there are a couple of places to keep the stop-loss. The first place to keep the stop-loss is just above the right shoulder while the second option is to keep the stop-loss below the head. The stop-loss below the head is considered safer as it offers added protection in the event of a sudden price fluctuation. However, the position of the stop-loss largely depends on your risk appetite and trading style and it can be adjusted accordingly.
When trading the head and shoulders pattern, the take profit is usually determined by measuring the distance between the neckline and the bottom of the head. For instance, if you are trading Forex and the distance between the neckline and the peak of the head is 100 pips then your potential take profit will also be 100 pips. However, this is just a guideline and you can adjust the take profit based on the price action and nearby support levels. Traders also use Fibonacci retracement or a long-term moving average to place the take profit.