For traders, recognizing chart patterns is akin to reading the market's treasured truths. Amongst these patterns, the inverse head and shoulders (H&S) stands as a beacon for trend reversals. It’s a chart pattern used by many traders and it can be used in Forex, stocks, crypto, or other markets, but what is it really, and how can you use it in your trades?
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What is an inverse head and shoulders pattern?
The Inverse Head and Shoulders pattern is a chart formation that appears to be a baseline with three lows, the middle low being the deepest. This pattern is used in technical analysis to predict the reversal of a downward trend.
The pattern is named so because it resembles a head with two shoulders when viewed upside down. The 'head' represents the lowest point of the pattern, while the two 'shoulders' are the highs on either side of the head, which are roughly equal to each other. The 'neckline' is the level of resistance that the price must break through to confirm the pattern.
In an Inverse Head and Shoulders pattern, the price falls to a trough and then rises, then falls below the former trough and rises again, and finally, falls again but not as far as the second trough. Once the final trough is made, the price heads upward, towards the resistance found near the top of the previous troughs.
Traders consider the pattern complete when the price breaks above the neckline (resistance), indicating the start of a new upward trend. It's at this point that traders often choose to enter the market with a long position.
Remember that like all chart patterns, there's no guarantee the price will go as expected, so risk management strategies should always be used.
Inverse head and shoulders characteristics
- Formation during a downtrend: This pattern is typically found during a downtrend and signals a potential reversal of that trend.
- Three troughs: The pattern is made up of three troughs, with the middle one (the 'head') being the deepest and the two either side (the 'shoulders') being shallower and roughly equal in depth.
- Neckline: The 'neckline' is drawn by connecting the high points after each trough. This line acts as a level of resistance that the price must break through to confirm the pattern.
- Volume: Volume often plays a crucial role in this pattern. It usually declines throughout the pattern, with a spike when the price breaks through the neckline.
- Breakout: The confirmation of the pattern comes when the price breaks above the neckline. Traders often wait for this breakout before entering a long position.
- Price target: The price target after the breakout is typically calculated by measuring the distance from the neckline to the bottom of the head. This distance is then projected upward from the neckline.
Inverse head and shoulders example
An example of an Inverse Head and Shoulders pattern can be seen in various market scenarios. Let's consider a hypothetical situation:
Let's say stock XYZ has been in a downtrend for several months, but then it forms a low point (Left Shoulder) at $50. The stock then rallies to $60 before falling again to form a deeper low (Head) at $45. After this, the stock rallies again to $60 and then falls one last time to form another low (Right Shoulder) at $50, which is similar to the first low.
So, the pattern here is a low ($50), a lower low ($45), and then a higher low ($50), with intermittent highs at the same level ($60), forming the neckline.
The Inverse Head and Shoulders pattern would be confirmed when the price of the stock breaks above the neckline at $60 on significant volume. This breakout is used by traders as a signal to enter a long position, anticipating that the previous downtrend has reversed.
How to trade an inverse head and shoulders
Step 1: Identify the pattern
The first step is to identify the pattern on the price chart. This involves a downtrend followed by three lows: the left shoulder, head (the lowest point), and the right shoulder. The shoulders should be roughly equal in depth, and the head should be deeper. The neckline is drawn by connecting the high points after each trough.
Step 2: Volume check
Volume should decrease as the pattern forms and then increase significantly during the breakout. This is a secondary confirmation signal.
Step 3: Wait for the breakout
The key to this pattern is waiting for the price to break above the neckline. This is the confirmation signal that the downtrend may have reversed. Avoid jumping in too early - false breakouts could occur.
Step 4: Entry point
Once the price breaks above the neckline with significant volume, you can consider entering a long position. Some traders prefer to wait for a retest of the neckline before entering.
Step 5: Set your stop loss
Always set a stop loss to manage your risk. A common place is just below the right shoulder or the breakout candle.
Step 6: Determine the profit target
The profit target is typically set at a distance from the neckline that's equivalent to the distance from the neckline to the bottom of the head. For example, if the distance from the neckline to the head is $100, you would set your profit target $100 above the neckline.
Step 7: Exit the trade
Exit the trade once the price reaches your profit target or hits your stop loss. If the price doesn't reach your profit target but starts showing signs of reversing, consider exiting the trade to protect your profits.Ready to try the inverse head and shoulders in your trades? Open a free Skilling trading account or open a demo account to familiarise yourself with online trading and trading strategies before using real funds.
Summary
As you've seen, the inverse head and shoulders pattern is a popular tool used by traders and investors to identify potential reversals in bearish trends. It's characterised by three troughs - the head being the deepest and the shoulders being less deep and roughly equal. However, like all chart patterns, it's critical to remember that the Inverse Head and Shoulders does not provide a guaranteed prediction of market behaviour. While it can be a useful part of a trading strategy, it should not be used in isolation. Other factors such as market conditions, fundamental analysis, and risk management considerations should also play a significant role in your decision-making process.
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FAQs
1. What distinguishes an inverse H&S from a regular H&S pattern?
The regular H&S pattern is a bearish reversal, with the head being the highest peak. An inverse H&S, conversely, signifies a bullish reversal, with the head being the lowest trough.
2. Is the volume increase seen as the pattern develops crucial for the pattern's confirmation?
Yes, a substantial rise in trading volumes during the formation of the right shoulder is pivotal as it underscores the pattern's strength and potential for a bullish reversal.
3. What happens if the price fails to breach the neckline?
A failed breakout is a sign that the bullish momentum is not sufficiently strong, and thus, the investor should be cautious about entering a long trade.
4. Can the length of time for a pattern to form affect the pattern's reliability?
Patterns that take too long to form may see the significance of their breakout diminish due to lengthier timeframes, changing market conditions, and other intervening events.
5. How does one measure the price target after the pattern's confirmation?
The expected price target is typically measured by calculating the distance from the head to the neckline to the break-out level. This distance is often taken as a rough estimate of the potential move's height.
6. Are there tools available to help traders spot this pattern more easily?
Many technical analysis software and charting platforms offer pattern recognition tools that automatically identify potential inverse H&S patterns.
7. Can an inverse H&S indicate the end of a down-trend and the beginning of a new market cycle?
Yes, an inverse H&S is often considered a reliable signal for a market cycle's change as it marks the start of an uptrend following a prolonged bearish phase.
8. Does the inverse H&S pattern work for all types of assets?
While the inverse H&S pattern is commonly used in equity markets, it can also be observed in other financial assets such as cryptos, Forex etc. indicating a bullish reversal in those markets as well.
9. In what timeframe is the inverse H&S pattern most effective?
The inverse H&S pattern is tradable on various timeframes, although it’s often most effective on daily or weekly charts for longer-term investors.
10. What are the key pitfalls traders should avoid when dealing with the inverse H&S pattern?
Traders should be mindful of two common pitfalls: overtrading based on overconfidence in this single pattern and ignoring risk management principles when executing trades based on inverse H&S signals.
