Are you looking to understand how the inverse head and shoulders pattern can enhance your trading strategy? Whether you’re just getting started with chart patterns or you’re an experienced trader seeking more reliable signals, mastering the inverse head and shoulders can be a game changer. This powerful technical pattern can help you identify key market trends and potential reversals, giving you the edge you need for more consistent profits.
In this blog, we’ll break down how to spot and trade this pattern, along with tips to maximize your trading success. If you’re new to technical analysis, you may want to check out our guide to different types of trading strategies to build a solid foundation for your journey.
What is an Inverse head and shoulder pattern?
Let’s travel to the core concept of inverse head and shoulder pattern! All you need to pack for this exciting journey is five things: Downtrend, First shoulder, Neckline, head, ummm…last but not least, the second shoulder!
The journey starts with a downtrend. Not all the downtrends will end up forming an inverse head and shoulder pattern, so you need to fasten your seatbelt to the end of this path!
A slight push from buyers causes prices to rise, and right there, you can spot the left shoulder forming. You might wonder how that could possibly resemble a shoulder, let alone the left or right one. But be patient—Rome wasn’t built in a day!
In the following, the market recovers from significant resistance as it starts to go up, and the downward trend restarts. This resistance level forms what is called the neckline. Your antennae might go up here but don’t rush, as many traders fail here. The head of the pattern is formed when the market finds firm support following a lower low. The second shoulder is formed by the neckline when the market again encounters resistance.
Although the pattern has not yet been established, the inverse head and shoulders pattern is beginning to take shape.
Key Takeaways
Inverse head and shoulder patterns help us predict a downtrend’s potential reverse. There are three success troughs, with the middle trough being the deepest. Consider the following condition when looking for an inverse head and shoulders pattern:
- The pattern looks like a person doing a handstand, with three main dips (or troughs).
- The “Head” is the lowest point in the middle.
- The “Shoulders” are two smaller dips on either side of the Head
Confirming the Pattern
To confirm an inverse head and shoulders pattern, traders typically look for a clear breakout above the neckline, which serves as the resistance level connecting the peaks of the two shoulders. This breakout should be supported by a significant rise in trading volume, indicating robust market interest and momentum. Furthermore, numerous traders prefer to observe a retest of the neckline following the breakout, confirming its role as new support and reinforcing the validity of the pattern. Employing additional indicators, such as moving averages or the relative strength index (RSI), can assist in confirming the upward trend and minimizing the probability of false signals.
Head and Shoulders Pattern Psychology
The psychology behind the inverse head and shoulders pattern reflects a shift in market sentiment from bearish to bullish. This pattern indicates that sellers (bears) are losing control, and buyers (bulls) may take over, signalling a potential price increase.
Identify inverse head and shoulder pattern
To identify this pattern, a trader is looking for these three things:
(1) An initial trend down to place the pattern in the context of a possible reversal;
(2) A clear, symmetrical head-and-shoulders formation. Symmetry is usually preferred, but it is not guaranteed.
(3) A move above the neckline on increased volume, which gives the pattern more validity.
This breakout usually gives a good buying opportunity, with the price target estimated by adding the height of the pattern from the head to the neckline to the breakout level.
This breakout usually gives a good buying opportunity, with the price target estimated by adding the height of the pattern from the head to the neckline to the breakout level.
Trading the Inverse Head and Shoulders Pattern
Imagine you want to trade and see the second should forming in the chart. What would you do? You need to confirm the head and shoulder pattern by seeing the market close above the neckline resistance. When? You may ask. Before or after? The ideal time frame for maintaining neckline resistance will determine that.
The process starts by seeing a low in the candlestick chart followed by a small bounce upward. Congrats! You are spotting the left shoulder. Then, the candles take another dip, going even lower to form the head of the inverse head-and-shoulders pattern. But wait! Don’t jump to conclusions yet—this is where many traders get trapped.
Patience is the key. You need to wait for the right shoulder. After forming the head, prices rise again but fail to make a new high, dipping slightly to create the right shoulder before making another move upward.
The highs of the left shoulder, head, and right shoulder are connected to form the neckline. A bullish reversal signal is confirmed when the price breaks above the neckline with strong volume. Now that we’ve nailed the concept let’s check out more examples—because mastering this pattern comes from practice.
For example, in the image below, a clear human stands upside down; the head, right, and left shoulder are totally distinguishable.
How to Trade the Inverse Head and Shoulders Like a Pro
Importance of Broker Selection
The choice of broker is crucial because each broker may offer different spread types (fixed or variable) and sizes. These differences can significantly affect your trading costs and profitability. You can easily decrease your trading costs by registering with a regulated broker like ITB.
Confirm the Breakout Before Entering
One common mistake traders make is entering a trade too early. Wait for a clear breakout above the neckline with strong volume confirmation. A premature entry can lead to false breakouts and unnecessary losses.
Use Stop-Loss Strategically
To minimize risk, place your stop-loss order below the right shoulder or just under the recent swing low. This ensures that if the pattern fails, your losses are limited. Adjust your stop-loss as the trade moves in your favour.
Combine with Other Indicators
For higher accuracy, use additional technical indicators like the Relative Strength Index (RSI) or Moving Averages to confirm trend reversals. A bullish RSI divergence can further validate the strength of the breakout.
Set Realistic Profit Targets
Measure the distance between the head and the neckline and project it upward from the breakout point. This gives a reasonable price target. Avoid being overly ambitious, and lock in profits at key resistance levels.
Monitor Market Conditions
The inverse head and shoulders pattern works best in bullish market conditions. Be aware of major news events and overall market sentiment before entering a trade. Economic announcements can cause unexpected volatility.
Example Trade
If a stock forms an inverse head-and-shoulders pattern with a head at $80, a neckline at $100, and shoulders at $90, it signals a potential bullish reversal. When the stock price breaks above the neckline at $100 with strong volume, it presents an opportunity to enter a long position. The height of the pattern, calculated as the difference between the neckline and the head ($100 – $80), is $20. This height is then added to the neckline to determine the target price, which in this case is $120 ($100 + $20).
Why Spotting False Breakouts is Crucial?
You may come across this term (inverse head and shoulder) and wonder what it means and why it matters. Having gained a full understanding of the concept, we are now excited to discuss its importance.
What really matters is that we need to detect false breakouts. As it happens when the price moves above the neckline but quickly reverses, failing to sustain the upward momentum. To simplify this concept, when traders buy an asset because they believe its price is starting to rise (a breakout), they can lose money if the price doesn’t actually keep going up as expected. This is called a “false breakout.”
False breakouts can make traders nervous and lead them to make emotional decisions, like selling too soon or ignoring their pre-set safety rules (stop losses).
A false breakout could indicate that the asset isn’t ready for an upward move, suggesting that the market sentiment may still be bearish. In such situations, traders should pause, reassess their strategies, and pay special attention to their risk management approach. This leads us to an important question: How can you outsmart false breakouts?
Haste Makes Waste
We’ve summarized all the possible strategies into concise bullet points. Read them to protect yourself from falling into the trap of false breakouts!
- Price retracement: After breaking the neckline, the price often retests it as new support before resuming the upward trend.
- Validation of the pattern: A successful retest strengthens the pattern’s validity and confirms a bullish reversal.
- Secondary entry point: The retest offers traders who missed the initial breakout another chance to enter, often with reduced risk through a tighter stop loss. A successful retest signals a change from bearish to bullish sentiment as the neckline transitions from resistance to support.
- Potential false breakout: If the price fails to hold above the neckline, it may indicate a false breakout, requiring traders to reassess their strategy.
Key Tips:
Always wait for confirmation of the breakout to avoid false signals. For higher accuracy, combine the pattern with other technical indicators, like RSI or MACD.
Conclusion
The inverse head and shoulders pattern is one of the key inventions in the area of technical analysis, helping a trader with a good platform to indicate a possible bullish reversal in a downtrend. Understanding its elements of head, shoulders, and neckline and the behind-the-scenes psychology of market players, a trader can efficiently guess any change in market sentiment. But mastering this pattern is not just about recognizing it; it’s about confirming it carefully with volume analysis, retests of the neckline, and applying complementary indicators to confirm a potential breakout. Aware of the danger of false breakouts and practicing good risk management, traders will limit their losses while taking advantage of trading opportunities. This novel approach enhances trading precision and strengthens a trader’s ability to navigate the complexities of market behavior effectively.
It usually occurs when the price breaks above the neckline with significantly increasing volume to confirm the pattern. Some traders prefer to wait for a retest of the neckline as support before entering to reduce risk.
The success rate of the inverse head and shoulder pattern is approximately 85%. The head and shoulders pattern is considered one of the most reliable trend reversal patterns. One of several top pattern signals, with varying degrees of accuracy, that an upward trend is nearing its end.
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