Inverse Head And Shoulders Pattern: Definition And Trading Tips

An inverted head and shoulders pattern is a technical analysis pattern that signals a potential reversal from a downtrend to an uptrend.

This article will explore the definition of this pattern, its structure, how it works, when it occurs, how to identify it, the best time to trade it, and the pros and cons of using it in your trading strategy.

Key Takeaways

• An inverse head and shoulders pattern signals a potential reversal from a downtrend to an uptrend.

• This pattern includes a left shoulder, head, right shoulder, and neckline, crucial for identifying the reversal.

• Confirmation at the neckline breakout, supported by volume analysis, enhances the reliability of the pattern.

What is an Inverted Head and Shoulders Pattern?

An inverted head and shoulders pattern, also known as a reverse head and shoulders, is a chart pattern used in technical analysis to predict a reversal in the trend of a security.

It consists of three parts: two shoulders and a head in the middle.

This pattern is considered a reliable indicator that the current downtrend will likely reverse into an uptrend.

This pattern is typically formed at the end of a prolonged downtrend and indicates a shift in market sentiment from bearish to bullish.

Traders look for this pattern to identify potential buying opportunities as it signals that the asset may start to rise in value.

Inverted Head and Shoulders Pattern Structure

The structure of an inverted head and shoulders pattern includes several key components:

• Left Shoulder: This part of the pattern begins with a price decline, forming the first trough. After this decline, the price rises slightly, creating a peak that marks the top of the left shoulder.

• Head: The head is formed by a more pronounced decline, which drops below the level of the left shoulder, creating the lowest trough in the pattern. This is followed by another rise, forming a peak that is higher than the previous one but still lower than the neckline.

• Right Shoulder: Similar to the left shoulder, the right shoulder is created by another decline that is generally similar in length to the left shoulder but does not drop as low as the head. This decline is followed by another rise.

• Neckline: The neckline is the resistance level that connects the peaks of the left shoulder, head, and right shoulder. When the price breaks above this line, it signals a potential reversal and serves as an important confirmation of the pattern.

Is the Inverse Head and Shoulders Pattern Bullish or Bearish?

The inverse head and shoulders pattern is considered a bullish indicator in technical analysis.

As mentioned before, it signals a reversal from a downtrend to an uptrend, suggesting that the price of a security is likely to rise.

This pattern is particularly significant because it indicates a shift in market sentiment from bearish (pessimistic) to bullish (optimistic).

How Does an Inverse Head and Shoulders Pattern Work?

The inverse head and shoulders pattern works by indicating a change in market sentiment.

During a downtrend, sellers typically dominate, pushing prices lower. However, as the pattern forms, the declining momentum weakens, and buyers begin to step in, especially at the right shoulder.

The break above the neckline confirms the shift from a bearish to a bullish trend.

When Does an Inverse Head and Shoulders Pattern Occur?

We’ve established that the inverse head and shoulders pattern occurs at the end of a significant downtrend.

Here’s a more detailed look into this pattern:

Key Conditions for the Pattern

• Prolonged Downtrend: The pattern usually forms after a prolonged downtrend where the price has been steadily declining. This downtrend reflects persistent selling pressure and bearish sentiment in the market.

• Oversold Conditions: During the downtrend, the security may reach oversold conditions where its price has dropped significantly, attracting potential buyers who believe the price is undervalued.

• Diminishing Selling Pressure: As the pattern forms, the selling pressure begins to diminish, and buying interest starts to increase, leading to the formation of the left shoulder, head, and right shoulder.

• Volume Analysis: Inverse head and shoulders volume analysis is crucial. Typically, volume decreases during the pattern formation and then increases significantly upon the breakout above the neckline, confirming the bullish reversal.

How to Identify an Inverse Head and Shoulders Pattern?

Let's consider an example of the inverse head and shoulders pattern occurring in a stock like ABC Corp to see how to identify the pattern:

• Prolonged Downtrend: ABC Corp’s stock has been in a downtrend for several months, dropping from $50 to $20.

• Left Shoulder: The stock price falls to $20, then rises slightly to $25, forming the left shoulder.

• Head: The price drops further to $10, marking a new low (the head), then rises again to $25.

• Right Shoulder: The stock price declines once more to $20 (higher than the head), followed by a rise to $25, forming the right shoulder.

• Neckline: The highs at $25 form the neckline. The inverse head and shoulders pattern confirmation occurs when the stock price breaks above this $25 level with increased volume to reach $35.

So, to analyze this formation, we’ll conclude:

• The pattern forms over weeks, signaling the downtrend might end.

• Volume decreases during formation but surges at the breakout, confirming it.

• The breakout above $25 indicates a shift to bullish sentiment, suggesting a buying opportunity and potential price rise.

What is the Best Time to Trade an Inverse Head and Shoulders Pattern?

The best time to trade an inverse head and shoulders pattern is after the pattern has fully formed and the price has broken above the neckline.

This breakout is considered the inverse head and shoulders pattern confirmation, indicating a higher probability of an uptrend.

Inverse Head and Shoulders Pattern Pros and Cons

Here are the pros and cons of the inverse head and shoulders pattern:

Pros:

• Reliable Reversal Signal: Often indicates a significant trend change.

• Clear Entry and Exit Points: The neckline provides a clear level to place buy orders and stop losses.

• Volume Analysis: Inverse head and shoulders volume analysis can further confirm the pattern, as rising volume on the breakout adds validity.

Cons:

• False Breakouts: Sometimes, the price breaks the neckline and then falls back below, leading to potential losses.

• Complex Identification: It can be challenging for novice traders to identify the pattern without sufficient practice correctly.

Inverted Head and Shoulders Pattern Trading Tips

• Only enter a trade after the price breaks above the neckline with increased volume.

• Ensure volume increases during the breakout for added confirmation.

• Place a stop-loss below the right shoulder to manage risk.

• Use other technical indicators like RSI or MACD to confirm the pattern.

• Wait for a clear formation of the pattern to avoid false signals.

• Use proper position sizing and risk management techniques to protect your capital.

Conclusion

The inverse head and shoulders pattern is a powerful tool for predicting trend reversals from bearish to bullish.

Recognizing its structure, including the left shoulder, head, right shoulder, and neckline, is crucial. Key elements like inverse head and shoulders volume analysis and confirmation at the neckline breakout are essential for effective trading. Join XS today and start trading!

FAQs

What Happens After an Inverse Head and Shoulders Pattern?

After an inverse head and shoulders pattern, the price typically reverses from a downtrend to an uptrend.

The breakout above the neckline confirms this reversal, indicating a potential increase in price as bullish sentiment takes over.

How Reliable is the Inverse Head and Shoulders Pattern?

The inverse head and shoulders pattern is generally considered a reliable indicator for predicting trend reversals.

However, its reliability increases when confirmed with volume analysis and other technical indicators.

How Accurate is the Inverse Head and Shoulders Pattern?

The inverse head and shoulders pattern can be highly accurate, especially when used in conjunction with other technical analysis tools.

Nonetheless, false breakouts can occur, so traders should use proper risk management strategies.